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Choosing an Education Loan

Choosing an Education Loan

The cost of an education loan is usually the most important criterion.

Mark Kantrowitz

April 21, 2009

All other loans — including the unsubsidized Stafford loan, the PLUS loan and private student loans — are unsubsidized. This means that the interest continues to accrue and is the responsibility of the borrower. If the borrower so chooses, the interest can be deferred by capitalizing it. This adds the interest to the loan balance, increasing the size of the loan. It is a form of negative amortization, in which the loan keeps on getting bigger and bigger.

In all cases borrowers have the ability to begin making payments sooner if they wish, since education loans do not have prepayment penalties. Borrowers can choose to make payments of the interest as it accrues or payments of principal and interest, or they can defer payments of principal and interest until they enter repayment. It is a good idea to pay at least the interest during the in-school and grace periods to prevent the loan from growing. Some private student loan lenders will give the borrower a small discount on the interest rate or fees if the borrower commits to paying the interest during the in-school and grace periods. Other private student loan programs require borrowers to make interest-only payments during the in-school and grace periods. This keeps the borrower informed about the amounts borrowed and the cost of the loan, discourages overborrowing, and helps the borrower establish good credit while they are still in school.

Loan Term

The loan term is the number of years the loan will be in repayment. This affects the size of the monthly payment. A longer loan term reduces the size of the monthly payment, but at a cost of increasing the total interest paid over the life of the loan. For example, increasing the loan term on a Federal Stafford loan from 10 years to 20 years cuts the monthly payment by about a third (34%), but more than doubles the total interest paid over the life of the loan (a factor of 2.18 increase in the total interest). It is best to stick with the shortest loan term you can.

Federal education loans offer several different repayment programs:

  • Standard repayment uses level payments for a ten year term. The monthly payments are the same and exceed the interest that accrues. The payments are first applied to interest and then to reducing the principal balance of the loan.

  • Extended repayment is like standard repayment, but the loan term ranges from 10 years to 30 years depending on the balance of the loan. This requires you to consolidate your loans, which is like a refinance that merges your loans into a single loan. Examples of the extended repayment terms include 15 years ($10,000), 20 years ($20,000), 25 years ($40,000) and 30 years ($60,000). There is a version of extended repayment that does not require consolidation and which provides a 25 year term if your total loan balance with a single lender is at least $30,000.

  • Graduated repayment starts off with low monthly payments and steps up the payments every two years.

  • Income-based repayment caps the monthly payment based on a percentage of your discretionary income (15% of the amount by which income exceeds 150% of the poverty line). It is best for borrowers who have high debt and low income. It is better than its predecessors, income-contingent repayment and income-sensitive repayment.

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