The most important criterion for choosing a student loan is cost. Most borrowers prefer a lower-cost loan. Key factors that affect the cost of a student loan are the interest rate and the length of the repayment term.
Student loan debt is unavoidable, given that more than two-thirds of college students graduate with … [+]
The Cost of a Student Loan
The cost of a loan depends on the interest rate, loan fees, discounts and rewards, interest capitalization frequency, loan forgiveness options and the length of the repayment term.
A higher interest rate means higher cost. A lower interest rate means lower cost. However, borrowers should prefer fixed rates when interest rates are low, even if fixed rates are higher than variable interest rates, because a variable rate has nowhere to go but up. A lower variable rate can save money, but only if you pay off the debt in full before interest rates rise too much.
There is a tradeoff between interest rates and loan fees. An 1% percentage point increase in the interest rate is the equivalent of a 4% percentage point increase in the loan fees on a 10-year repayment term. So, a loan with 4% fees and a 9% interest rate costs more than a loan with 5% fees and an 8% interest rate.
Loan forgiveness can reduce the cost of a student loan, but most borrowers will not qualify. Even when a borrower qualifies for loan forgiveness, some loan forgiveness programs require the borrower to have been in repayment for 20 or 25 years, increasing the total cost of the loan.
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Overall, the interest capitalization frequency has a small impact on the cost of a student loan. If interest on a 5% loan is capitalized monthly, it increases the effective interest rate during a 12-month forbearance by about 0.1% as compared with a loan that capitalizes the interest once, at the end of the forbearance period.
Impact of the Repayment Term on Cost
The length of the repayment term can have a big impact on the cost of a student loan.
When comparing the cost of two loans, consider both the monthly loan payments and the total payments over the life of the loan. Differences in repayment terms can affect the total interest paid over the life of the loan, not just the monthly loan payment.
A shorter repayment term will reduce the total loan payments, but increase the monthly loan payment. Likewise, a longer repayment term will decrease the monthly loan payments, but increase the total loan payments.
For example, a 5-year repayment term has 11% lower total payments than a 10-year repayment term, assuming a 5% interest rate, but the monthly payments are more than three-quarters higher. A 20-year repayment term has monthly payments that are about a third lower than a 10-year repayment term, but total payments that are about a quarter greater. A 30-year repayment term cuts the monthly payments in half compared with a 10-year repayment term, but increases the total payments by more than 50%.
It isn’t always possible to use the same repayment term to compare loans with different interest rates. In a rising-rate environment, fixed-rate loans will require a shorter repayment term for lower interest rates.
Use a student loan calculator to compare both the monthly loan payment and total payments over the life of the loan.
The annual percentage rate, or APR, combines the impact of the interest rate and fees for a specific repayment term. Although the APR is intended to make it easier to compare loans, APR works well only when the two loans have the same repayment terms. When the repayment terms differ, the longer repayment term will yield a lower APR, even though the loan with the longer repayment term will cost more money.
Shop Around for the Best Loans
The lowest advertised interest rate is not necessarily the interest rate you’ll get. In fact, more borrowers get the highest advertised interest rate than the lowest. Only borrowers with excellent credit scores will qualify for the lowest interest rates.
Lenders do not publish their interest rate formulas, so you’ll have to apply for several loans to find the one that offers you the best interest rate and fees.
Generally, federal student loans offer the lowest cost and the best combination of repayment terms for most borrowers. They do not depend on the borrower’s credit scores or income, unlike private student loans. The unsubsidized Federal Stafford loan and the Federal PLUS loan do not depend on demonstrated financial need. Even wealthy students can qualify for these loans. The Federal Stafford loan is lower cost than the Federal PLUS loan.
Apply for Private Student Loans with a Creditworthy Cosigner
Apply for private student loans with a creditworthy cosigner.
Private student loans base eligibility and interest rates on your credit score and the credit score of your cosigner, whichever is higher. (Eligibility also depends on the borrower’s income, debt-to-income ratios and the duration of employment with the borrower’s current employer.)
So, applying for a private student loan with a cosigner will not only increase your chances of getting approved for the loan, but may also result in a lower interest rate.
More than 90% of private student loans for undergraduate students required a creditworthy cosigner. These loans are approved on the strength of the cosigner’s credit, not the borrower’s, because most students have a thin or non-existence credit history.
There is, however, one caveat, which is the risk to the cosigner. Many parents incorrectly assume that cosigning a loan is like giving a reference for the borrower. But, it is much more than that. A cosigner is a coborrower, equally obligated to repay the debt. Lenders seek repayment from the borrower first, as a courtesy. But, as soon as the borrower is late with a payment, the lender will start requiring the cosigner to make the loan payments.
Check Your Credit Reports before Applying for a Private Student Loan
Errors in your credit reports can affect your credit score, which in turn affects the interest rates you pay.
Check your credit reports for errors before applying for a private student loan.
You can get your credit reports for free at annualcreditreport.com.
If you notice any errors, you can get them corrected by disputing them. The lender has 30 days to correct an error or confirm its accuracy.
So, you should check your credit reports at least 30 days before you plan on applying for a private student loan.
