Choosing an Education Loan
The cost of an education loan is usually the most important criterion.
April 21, 2009
Most private student loans offer repayment terms of 15 to 30 years, with 20 years being the most common. They use a longer repayment term to reduce the monthly payments below the monthly payments on a 10-year federal student loan despite the higher interest rates and fees on the private student loan. This makes the loans seem more affordable even though the total cost is much higher.
For example, let’s compare $20,000 federal and private student loans. The federal Stafford loan has a 10 year term and a 6.8% interest rate, yielding monthly payments of $230. The private student loan has a 20 year term and a 10% interest rate, yielding monthly payments of $193. That makes the private student loan seem cheaper, until you realize that the total payments on the private student loan are $46,323 (of which $26,323 is interest), much higher than the total payments of $27,619 on the federal Stafford loan (of which $7,619 is interest). So always ask not just about the monthly payments, but also about the total cost of the loan.
Cost of the Loan
Besides the loan term, the interest rates, origination fees and default fees have the biggest impact on the cost of the loan. The interest rate is a fee charged annually (or monthly) based on a percentage of the outstanding balance owed on the loan. The origination and default fees are one-time fees charged up-front based on the initial balance of the loan. These fees are always deducted from the disbursement check and are never collected in advance. (If someone asks you to pay the loan fees in advance, it can be a warning sign of an advance fee loan scam.)
For example, the PLUS loan has an interest rate of 8.5% in the federally-guaranteed student loan program (7.9% in the Direct Loan program) and fees of 4%. The unsubsidized Stafford loan has an interest rate of 6.8%.
Fees are effectively a form of up front interest, like points on a mortgage. A good rule of thumb is that 4% in fees on a ten year loan is the equivalent of about a 1% increase in the interest rate. For example, the 8.5% rate with 4% fees on the ten-year PLUS loan would be the equivalent of a 9.45% rate loan with no fees. The rule of thumb breaks down on longer term loans, yielding a somewhat lower increase in the interest rate to yield a no-fee loan. Use FinAid’s no-fee equivalent interest rate calculator to evaluate the impact of fees on the cost of the loan.
FinAid also provides a loan payment calculator you can use to calculate the monthly payments on a loan.
Some lenders offer discounts on the interest rates and fees. These discounts are often small and may have stringent requirements for continued receipt. The most common discount is a 0.25% interest rate reduction for having the monthly payments automatically debited from your bank account.
All else being equal, you should focus on the lowest cost loan. This is usually the loan with the lowest no-fee equivalent interest rate. It may be affected by the deductability of interest on the loan. Up to $2,500 in interest paid on qualified education loans may be deducted as an above-the-line exclusion from income of federal income tax returns. This means you can take the deduction, which reduces your adjusted gross income, even if you don’t itemize on Schedule A.