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The True Cost of Federal Student Loans: Read This Before You Borrow

After months of applying and waiting, you’ve finally been accepted into your ideal school. That means the hard part should be over, right?

Not quite—the next step is to figure out how to finance your higher education, which might mean taking out student loans. But just how do student loans work, anyway? In this article, we’ll help you make sense of the different types of student loans, all the costs they entail, and how to decide which loans make the most financial sense for you.

Understanding the Types of Federal Student Loans

There are four types of Federal student loan types: 

  • Direct Subsidized Loans are loans made to eligible undergraduate students who demonstrate financial need to help cover the costs of higher education at a college or career school.
  • Direct Unsubsidized Loans are loans made to eligible undergraduate, graduate, and professional students, but eligibility is not based on financial need.
  • Direct PLUS Loans are loans made to graduate or professional students and parents of dependent undergraduate students to help pay for education expenses not covered by other financial aid. Eligibility is not based on financial need, but borrowers who have an adverse credit history must meet additional requirements to qualify.
  • Direct Consolidation Loans allow you to combine all of your eligible federal student loans into a single loan with a single loan servicer.

Making Sense of Your Student Loan Documents

When applying for a loan, you might see some new terms that you haven’t encountered before. If you don’t recognize any of these words, please take a look at our glossary of terms that break each down in plain English. 

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.

What’s a Student Loan Origination Fee?

Now, let’s take a closer look at one of the most common extra charges: an origination fee. This is a fee charged up front 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.

The Basics of Federal Student Loan Repayment

Now let’s get back to the basics of interest and repaying your loan. 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 the 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 is 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 student loan repayment in our article How Do Earnest Loans Work?

Understanding the Student Loan Landscape

Increasing competition among student loan servicers means you now have a selection of loans 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, has higher rates, steep origination fees and does require a minimal credit check. In some cases, private student 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 and options to save the most money over the life of your loan.

Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.