The most important criterion in choosing a student loan is the cost. Most borrowers prefer a lower cost loan. The main factors that affect the cost of a student loan are the interest rate and the repayment term.
The cost of a student loan
The cost of a loan depends on the interest rate, loan fees, discounts and rewards, frequency of capitalization of interest, loan cancellation options, and repayment term.
A higher interest rate means a higher cost. A lower interest rate means a lower cost. However, borrowers should prefer fixed rates when interest rates are low, even if fixed rates are higher than variable interest rates, as a variable rate has no choice but to increase. A lower variable rate can save money, but only if you pay off the debt in full before interest rates rise too high.
There is a trade-off between interest rates and loan fees. A 1% increase in the interest rate is equivalent to a 4% increase in loan fees over a 10-year repayment term. Thus, a loan with 4% fees and 9% interest costs more than a loan with 5% fees and 8% interest.
Canceling the loan can lower the cost of a student loan, but most borrowers will not qualify. Even when a borrower is eligible for a loan forgiveness, some loan forgiveness programs require the borrower to repay for 20 or 25 years, which increases the total cost of the loan.
Overall, the frequency of interest capitalization has little impact on the cost of a student loan. If the interest on a 5% loan is capitalized monthly, it increases the effective interest rate for a 12-month tolerance period of about 0.1% compared to a loan that capitalizes the interest once, at the end of the tolerance period.
Impact of the repayment term on the cost
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 repayments, but will increase the monthly loan payment. Likewise, a longer repayment term will reduce the monthly loan payments, but increase the total loan payments.
For example, a 5-year repayment term has total payments 11% lower than a 10-year repayment term, assuming an interest rate of 5%, 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 higher. A 30-year repayment term halves the monthly payments compared to a 10-year repayment term, but increases total payments by more than 50%.
It is not 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 the 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, the APR only works well when the two loans have the same repayment terms. When the repayment terms differ, the longer repayment term will result in a lower APR, even though the loan with the longer repayment term will cost more.
Shop for the best loans
The lowest advertised interest rate is not necessarily the interest rate you will get. In fact, more borrowers get the higher advertised interest rate than the lower. Only borrowers with excellent credit scores will qualify for the lowest interest rates.
Lenders don’t publish their interest rate formulas, so you’ll have to apply for multiple loans to find the one that gives 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 are not dependent on the borrower’s credit scores or income, unlike private student loans. The Federal Stafford Unsubsidized Loan and Federal PLUS Loan are not dependent on demonstrated financial need. Even wealthy students can avail of these loans. The Federal Stafford loan is less expensive than the Federal PLUS loan.
Apply for private student loans with a creditworthy co-signer
Apply for a private student loan with a creditworthy co-signer.
Private student loans base eligibility and interest rates on your credit score and the credit score of your co-signer, whichever is greater. (Eligibility also depends on the borrower’s income, debt-to-income ratios, and length of employment with the borrower’s current employer.)
So, applying for a private student loan with a co-signer will not only increase your chances of getting the loan approved, but can also lower the interest rate.
Over 90% of private student loans for undergraduates required a creditworthy co-signer. These loans are approved on the basis of the credit of the co-signer, not that of the borrower, as most students have poor or no credit history.
There is, however, one caveat, which is the risk to the co-signer. Many parents mistakenly assume that co-signing a loan is giving the borrower a reference. But, it is much more than that. A co-signer is a co-borrower, also required to repay the debt. Lenders first ask the borrower for repayment, as a courtesy. But, as soon as the borrower is in arrears, the lender will start requiring the co-signer 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 find any errors, you can correct them by disputing them. The lender has 30 days to correct an error or confirm its accuracy.
You should therefore check your credit reports at least 30 days before applying for a private student loan.