- Interest rates add to the cost of borrowing money
An interest rate is simply the amount charged on an annual basis to borrow money. For instance, a 3.5 percent interest rate on $10,000 adds $350 to the cost of borrowing the money for one year. A 6.5 percent interest rate would add $650.
Interest rates can vary quite a bit. Federal student loans, such as Direct Subsidized and Direct Unsubsidized loans for undergraduate students have an interest rate of 5.05 percent for the 2018/2019 academic year. Graduate and professional students with Direct Unsubsidized loans have to pay at least 6.6 percent in interest to borrow funds. Parents, graduate students, and professional students with Direct PLUS loans pay 7.6 percent in interest.*
Private student loans can have variable interest rates that vary from about 4 percent to 12 percent, and fixed rates that can range from about 5 percent to 13 percent, depending on the lender.
Origination fees matter
While most people look primarily at the interest rate as the cost of borrowing funds, origination fees are also important.
Federal Direct PLUS student loans add a one-time fee of 4.248 percent (between October 2018-October 2019). The fee will be deducted upfront from your loan disbursement, so the amount you receive is less than the amount you borrowed. However, you have to pay back the full amount you borrowed, including the fee that was deducted.*
Private student loans generally don’t have origination fees. This may be a distinction to consider when applying for loans.
Interest charges can be added to your balance via capitalization
Accrued interest is considered part of your loan balance. Then interest can be charged on the principal amount. The process of interest being added to your principal amount is called capitalization.
For example if $1,000 in interest accrued while you had a deferment in college, this $1,000 would be added to your balance when you go into repayment. If you were charged 3.4 percent annually on this principal amount, you’d pay $34 annually on the interest that was capitalized.
There is an exception to when student loan interest is charged
While there are a variety of reasons for when interest isn’t charged, there is only one type of federal student loan that offers this exception: subsidized student loans.
Subsidized means the interest is paid by the government during certain time periods such as attending school at least half-time.