How Do Student Loans Work?

Transcript

Understanding Student Loans

Up until now, if you borrowed money from someone, all they probably expected you to do was pay it back. Lend a dollar, pay back a dollar. Seems fair enough. But for amounts as big as your college tuition, it’s a whole different story. Because the companies and organizations that lend you money, charge you for that privilege. And they make their money in three different ways: interest, time, and amount. Why do you need to know this? Because the more you can limit those three factors, the more you can protect yourself from owing more than you can handle. Let’s look at each one in turn.

Interest: The higher a loan’s interest rate, the more it costs you to pay it back.

The first factor is interest. As you probably know, the higher a loan’s interest rate, the more it costs you to pay it back. And since different kinds of lenders can charge you different amounts, we’re going to look at what that means by approximating three different types of loans: A low interest student loan from the Federal Government; a mid-range rate for something called a Parent Plus Loan; and a high interest rate you might get from a company that’s in the business of making loans. So with that in mind, let’s begin.

Say that over the course of your four years in college, you’ll need to borrow $6,000 a year to help cover your costs. That would be $24,000 in total. And let’s say you sign an agreement that you’ll pay it all back by 10 years after you graduate. If your interest rate is relatively low – we’ll use an average rate of 2.5 percent to represent that -- your loan will cost you 28,782 dollars to repay. That is - $24,000 to pay back the loan, and over 4,700 dollars more in interest. That’s not a small amount. But if your average interest rate is more in the middle range – say, 5%, you’ll have to pay back much more. With that rate, your $24,000 loan would cost you more than 34,000 dollars to pay back.
And if you get a loan with a high interest rate – something like 10 percent – then you’ll have to pay back over 48,000 dollars. Now think about that. And just imagine what else you could use the money for over those 10 years -- if you went with a low rate loan instead of a high rate. That’s the kind of difference that different interest rates can make. And it’s why it makes sense for you to look for as low an interest rate as possible.

Time: The longer it takes you to pay back your loan, the more you’ll have to pay.

Now what about this second factor – time? The rule there is pretty simple, too. The longer it takes you to pay back your loan, the more you’ll have to pay. For example, let’s go back to that $24,000 loan at two-and-a-half percent interest. As we noted before, if you pay it off in 10 years, it will cost you nearly $28,800 in total. But if you find a way to pay it off in 6 years, your costs would come down to 27,425 dollars. That’s more than a 1300 dollar difference!

On the other hand, if you take 15 years to pay off that loan, your total payback amount will be just above 30,500 dollars. Keep the same time frames, but bring it up to 10% interest – and things go through the roof! Your $24,000 loan would cost you $40,020 to pay back in 6 years, over $48,000 to pay back in 10 years, and nearly $59,000 to pay back in 15 years!

Now here’s something to keep in mind. Many lenders will try to make all this look more acceptable to you – by telling you that the longer they make your payment terms – the less you’ll have to pay each month. And that’s true… as you see here. Pay back a $24,000 loan at 2.5% interest in 6 years, and you'll be charged $381 a month. At 10 years, your payments are $240 a month. And spread your payments over 15 years, and they'll come down to $170 per month. But what you know now, is that the longer it takes to pay off your loan – the more it’s going to cost you. Pay the $24,000 loan back in six years, your cost is $27,425. Take ten years, your cost goes to $28,782. And pay it off over 15 years, you pay more than $30,500 dollars. The point: when it comes to student loans, time is NOT on your side. So far, we’ve seen how lenders make money on the rate of interest you pay, and the amount of time it takes you to repay your loan.

Amount: The more expensive the school, the more your loans will cost.

Now it’s time to look at the third factor: amount. This one has to do mainly with the cost of the college you go to. Obviously, the more expensive the college you choose, the more you’ll likely need to borrow. So let’s say you’re considering three schools, each one requiring you to borrow $6,000 more than the next. At 2.5% interest over a 10 year payback period, a $24,000 loan will cost you more than 4,700 dollars over what you borrowed. A $30,000 loan will cost you nearly $6000 more than you borrowed. And a $36,000 loan will cost over 7000 dollars more than the original loan amount. Bring the interest rate up to 10%, and you see how much more your costs will actually double. That $24,000 loan will cost you more than an additional $24,000 over what you borrowed. Your $30,000 loan will cost you $60,000. And a $36,000 loan will cost $72,000.

And remember, that difference between the loan amount and the payment amount goes to your lender, not to your college. So hopefully, you get the message. When you understand how interest rates, time and the amount of your loan can affect your costs, you have the ability to take things into your control – and make the choices that work best for you.