Common Loan Terms
Here we explain a few loan concepts that you should understand. Many of these terms may be familiar to you, and if so, you may move ahead quickly. But please make sure you understand them thoroughly before continuing.
And yes, there will be a quiz!
Subsidized vs. Unsubsidized Loans
You have probably heard of subsidized loans and unsubsidized loans, but do you know what a subsidy is? A subsidy is financial assistance that covers accruing interest.
When a subsidy exists on a loan, no interest accumulates during specific times: while in-school, during grace period, or in a qualifying deferment. Subsidized loans are very beneficial to you because they can save you money.
Subsidized loans include Direct Subsidized Stafford Loans, Federal Perkins Loans, Primary Care Loans, Loans for Disadvantaged Students (LDS), some Institutional Loans, and possibly a portion of a Direct Consolidation Loan (depending on the underlying loan type).
Alternatively, unsubsidized loans accrue interest from the date of disbursement. You may not actually be paying the interest while you are in school, but it is accruing and you will be responsible for it when repayment begins. Unsubsidized loans include Direct Unsubsidized Stafford Loans, Direct PLUS Loans, private loans, some Institutional Loans, and possibly a portion of a Direct Consolidation Loan (depending on the underlying loan type).
The interest rate is what the lender charges you to use their money - the price tag for the loan. Review the chart below, and notice that interest rates for Direct Stafford Loans for graduate students are fixed at 6.8% and Direct PLUS Loans are fixed at 7.9%. Perkins, PCL, and LDS Loans have a low fixed interest rate of 5%. Private loan rates are set by the lender and can be fixed or variable. Institutional loan rates depend on the institution, so check with your financial aid office for the interest rate on those loans.
Finally, if there is a Direct Consolidation Loan in your student loan portfolio, the rate will be dependent on when you received the loan and what loans you included in the consolidation.
The interest rate of these assorted loans can be different, so be aware when borrowing. For example, it would not make sense to take out a Direct PLUS Loan at 7.9% if you are able to borrow a Direct Stafford Loan at 6.8%. Borrowing wisely is important so we will cover this topic in the next section.
How Interest Accrues
For loans that are subsidized, accrued interest will be your responsibility if the subsidy is not available (meaning if your loans are not in a qualifying deferment or grace period). For loans that are not subsidized, interest begins to accrue on the loan as soon as it is disbursed, and you (the borrower) are responsible for repaying this accrued interest as well as the principal.
Student loans are simple interest loans and therefore the interest that accrues is based only on the principal balance of the loan. The total amount of interest to be paid is not a pre-determined amount because the borrower has the right to repay and prepay as aggressively as they prefer.
The cost of the loan is ultimately dependent on the term utilized by the borrower (said another way, the amount of interest that accrues on student loans depends on how long it takes the borrower to pay off the principal balance in full). To a large degree, you are in control of your total interest costs.
As a federal student loan borrower, you always have the option to pay interest on Direct Unsubsidized Stafford and Direct PLUS Loans - even while you are enrolled. Work with your servicer to determine the best way to send in voluntary interest payments if that is something you and/or your family choose to do.
At certain points in time, the unpaid accrued interest will capitalize. Capitalization is a cost of student loans that is invisible, but the impact is significant. Capitalization can increase the cost of your loans because it takes all accumulated interest that is unpaid (from loans such as your Direct Unsubsidized Stafford and Direct PLUS Loans) and makes it a part of the original principal balance. Once capitalization occurs, your new (and larger) principal balance begins accruing interest. In effect, your interest is now accruing interest. Typically , while in an in-school deferment, no capitalization will occur.
For those of you who are visual learners, here is an example of the capitalization a medical school student may experience. Obviously, it is not a positive process, and the less often it happens, the better.
As we saw earlier, the median balance of debt for the Class of 2011 was $162,000. For a medical student that took out $162,000 during medical school, they likely accrued $23,000 in interest (during four years of medical school and six months of grace). When this interest capitalized, the loans have a new, higher principal balance of about $185,000, and additional interest now accrues based on this higher balance.