After months of applying and waiting, you’ve finally been accepted into your ideal graduate program. That means the hard part should be over, right?
While many people think it’s as simple as taking out federal loans—or even a private loan with the lowest advertised rate—it’s actually a bit trickier than that. Why? All federal loans and some private loans have a kind of hidden cost, aka the origination fee which can tack on thousands of extra dollars to your student loan bill.
We’ll show you how to compare loan offers to determine which is the best financial decision for you.
Determining the True Cost of Your Loan
Analyzing your student loan interest rate might seem simple enough, especially if you’re only considering fixed rate loans. Just pick the lowest interest rate, right? But hold on, don’t sign on the dotted line yet.
Some lenders charge various fees in addition to the interest rate, which is why it’s equally important to look at any other costs associated with your loan. When you include all the fees and costs, this is called your annual percentage rate, or APR. This is true for any loan, whether that’s a student loan, personal loan, or even a credit card.
Factoring in Origination Fees
Now, let’s take a closer look at one of the most common extra charges: an origination fee. This is an upfront charge by your lender at the beginning of the loan term.
It’s typically determined as a percentage of your loan amount and is either deducted at the time of loan disbursement or rolled into your loan amount.
For example, a federal Direct PLUS loan has an advertised interest rate of 6.84% but also has an origination fee of 4.272%, under the rates posted as of May 2016. That means if you borrow $50,000, your origination fee would cost $2,136 and you’d only receive $47,864—even though your loan principal would still be $50,000.
In this scenario, the 10-year Direct PLUS loan’s APR is actually 7.626%—nearly a full percentage point over the originally quoted interest rate.
Other lenders might charge the same origination fee but tack it onto your original loan amount. So in this example you’d receive the $50,000 but your amount borrowed would increase to $52,136 with a similar origination fee.
Despite their differences, both methods affect your APR because fees (whether they are prepaid or not) add to the total cost of your loan. This is a key reason to look for lenders that have zero origination fees when shopping around for a student loan.
If you’re considering a Direct PLUS federal loan you may do well to look at other options.
Understanding the Basics of Repaying Your Loan
Now let’s get back to the basics of interest and repaying your loan. The interest rate is essentially the cost of borrowing money from your lender, charged as a percentage of your principal amount, or the balance of the amount you borrowed.
Each month your payment consists of both principal and interest. Many student loan lenders calculate interest using the “simple daily interest” method, meaning your interest accrues each day.
So if you have $20,000 in outstanding principal since your last payment and your interest rate is fixed at 6.21%, your daily interest accrued this month would be calculated as (1/365) * 0.0621 * $20,000 = $3.40
That means you’re charged approximately $3.40 in interest each day that month. If your next payment is 30 days later, simply multiply the two numbers ($3.40 * 30) to find your total monthly interest: $102. If your loan payment is $300 per month, $102 will go to interest and $198 to principal.
The following month, you’ll have paid down some of your principal, so the amount of interest you pay changes. If your interest rate if fixed, the payment amount will be the same, but a slightly higher percentage will go towards your principal. By your final loan payment, nearly all your payment will be going to principal.
You can read more about How Loans Work.
Putting It All Together
With the student loan marketplace becoming increasingly competitive among lenders, you have many more options available when comparing the best loan terms and rates.
While federal loans, particularly Stafford loans, are attractive both for lower rates and easy access, they have origination fees.
The federal Direct PLUS loan program, which is aimed at graduate students as well as parents, have higher rates, steep origination fees and do require a minimal credit check. In some case, private loans may be more competitive for borrowers so it pays to shop around.
The student loan landscape is changing every day to help students and graduates finance their educations without taking on insurmountable debt. Don’t assume the first quote you receive is the best; instead, take the time to analyze all of your repayment terms to save the most money over the life of your loan.