Private Loans - Understanding the Cost of Borrowing
It is always a good idea to do your homework before you make a major purchase or enter into a financial transaction, and private student loans should be no exception. The more you understand about the cost of borrowing – before you borrow – the better.
A note about private student loans
Private student loans are meant to supplement - not replace - federal student loans. Work with the financial aid office at your school to look into all other sources of federal, state, and school aid prior to borrowing a private student loan.
The Cost of Borrowing
The concept of a loan is pretty straightforward: first you borrow money, and then you repay it. But the amount that you must repay is more than the amount you borrow. This is due to interest and fees, which is what a lender charges you for the use of its money. It is also referred to as a finance charge. A finance charge is the dollar amount that the loan will cost you.
Lenders generally charge what is known as simple interest. The formula to calculate simple interest is: principal x rate x time = interest (with time being the number of days borrowed divided by the number of days in a year).
Consider the following:
- If you borrow a $2,500.00 loan with an interest rate of 5.00% for a period of one year, the interest you owe will be $125.00 ($2,500.00 x .05 x 1). This means you would repay a total of $2,625.00 ($2,500.00 + $125.00).
- The table below illustrates how a loan payment is applied first to the accrued interest owed, then toward your current principal balance, assuming a 24-month payment plan.
| Payment |
Amount applied
to interest |
Amount applied
to principal balance |
Principal balance |
| |
|
|
$2,500.00
|
|
$109.68
|
$10.42
|
$99.26
|
$2,400.74
|
|
$109.68
|
$10.00
|
$99.68
|
$2,301.06
|
|
$109.68
|
$9.59
|
$100.09
|
$2,200.97
|
APR (Annual Percentage Rate)
Federal law requires that lenders provide a Truth in Lending Act disclosure to consumers. This act requires the lender to disclose an annual percentage rate, or APR. The APR tells you the true cost of your loan. While the APR may not always include all costs, it does include the rate of interest being charged and all fees collected at the time the loan is made, so it is a reasonable indicator of the cost of your loan.
Other Fees
Some lenders charge additional fees, besides interest, for the privilege of borrowing money. Generally, these additional fees are a percentage of the loan amount that is deducted from the amount you receive, and they are charged immediately upon your receipt of the loan proceeds. For example, if the lender assesses a fee of 5% and the loan amount is $2,500.00, the fee will be $125.00 and you will receive $2,375.00. You must, however, pay back $2,500.00 to the lender. These fees are usually considered part of the finance charge; or, more specifically, a prepaid finance charge.
Other charges to be aware of include late charges, loan processing fees, and deferment and forbearance fees. Not all lenders assess these fees. The key to understanding the fees associated with your private student loan is to read the credit agreement, also known as a promissory note or note. This is a contract between you and the lender that says the lender will loan you money and you will repay it. Read it carefully, and do not hesitate to discuss it with the lender and your school financial aid administrator.
Compounding Interest
Many private student loan lenders allow borrowers to delay loan repayment until they either graduate or withdraw from school. During that time, the interest continues to accrue and may be added to the principal balance of the loan. Adding interest to the principal balance is known as compounding interest. Depending on the lender, interest can be added to the loan on a monthly, quarterly, semiannual, or annual basis.
Some lenders compound the interest near the time the borrower graduates from school, while other lenders do not ever add the accrued interest to the loan’s principal balance.
It is always best to pay accrued interest before it is added to the balance of the loan. You will save money in the long run by doing so. If your lender compounds accrued interest annually over a period of four years on a $2,500.00 loan with an interest rate of 5.00%, you will end up having $538.78 added to the balance of the loan by the time you begin repayment.
The more frequently a lender adds the interest to the principal loan balance, the more interest a borrower will pay. Look for a lender that does not compound the interest, or a lender that does so infrequently, and close to the time that repayment of the loan is scheduled to begin.
Putting it All Together
Imagine that you are considering whether to borrow $2,500.00 from Lender A or Lender B in the chart below. After weighing the options, you’ve decided to delay making payments on your loan until you graduate, which you anticipate doing in four years. You also receive a six-month period following graduation (grace period) before making payments.
Which loan is best for you? While the APR is a good measurement, it may not always be the best indicator given your particular circumstances. You also need to consider whether the monthly payments fit your budget, and whether the fee allows you to have all the money you need at the time you take out the loan.
| Lender A |
Lender B |
| Interest rate: 5.0% |
Interest rate: 4.75% |
Fee: $50.00
(2% of loan amount) |
Fee: $75.00
(3% of loan amount) |
| Loan term: 51 months in-school & grace period; 10-year repayment term following graduation |
Loan term: 51 months in-school & grace period; 10-year repayment term following graduation |
| Frequency of compounding interest while you are in school: semiannually |
Frequency of compounding interest while you are in school: annually |
| Finance charge: $1,476.40 |
Finance charge: $1,407.80 |
| Monthly payments: $32.72 |
Monthly payments: $31.94 |
| Total of payments: $3,926.40 |
Total of payments: $3,832.80 |
| APR: 5.21% |
APR: 5.05% |
The Truth in Lending Act Disclosure
The federal Truth in Lending Act requires lenders to disclose key terms of the lending arrangement and all costs in a uniform manner. An important component of the disclosure is the Federal Box, which appears near the top of the Truth in Lending Act disclosure. Using the information from Lender B in the comparison above, the Federal Box would look like this:
| Annual Percentage Rate |
Finance Charge |
Amount Financed |
Total of Payments |
| The cost of your credit as a yearly rate. |
The dollar amount the credit will cost you. |
The amount of credit provided to you or on your behalf. |
The amount you will have paid after you have made all payments as scheduled. |
| 5.05% |
$1,407.80 |
$2,425.00 |
$3,832.80 |
Note that while you will be repaying $2,500.00, the Amount Financed shows $2,425.00. The Amount Financed is calculated by subtracting any prepaid finance charges ($2,500.00 minus $75.00, or $2,425.00).
This information provided courtesy of the National Council of Higher Education Loan Programs, Inc., (NCHELP).