If you’re shopping around for a student loan, you might see lenders display their annual percentage rate (APR). The APR is the total cost of borrowing per year, including fees and expenses. Comparing APRs is often a more reliable way to choose a loan than reviewing interest rates alone. Here, we’ll explore the differences between interest rates and APRs.
What Is a Loan’s Interest Rate?
The interest rate is the periodic payment you must make on your loan balance. It’s the main cost of taking out a loan. An interest payment is usually a percentage of your outstanding balance, which you must pay monthly, quarterly, or annually.
Calculating Your Interest Payments
To determine how much you owe, multiply your interest rate by your outstanding balance. For example, let’s say you have a $10,000 loan with a 5% interest rate. Let’s also assume the bank requires annual interest payments.
Here, you’ll need to pay 5% of $10,000 at the end of the year, which is $500. Note that if you don’t pay down any of the original loan amount – the “principal” – you’ll have to keep paying $500 each year because your balance will always be $10,000.
Now, let’s say you pay $1,000 at the end of the year instead of $500. In this case, you’d be paying off your $500 interest payment, plus you’d pay down $500 of your principal amount. In that case, you’d owe $9,500 of principal the following year ($10,000 minus $500). So, when next year comes around and you need to make your interest payment, you’d need to pay 5% of $9,500, which is $475.
As this example shows, the faster you can pay down your principal amount, the less interest you’ll have the pay over the term of your loan.
Another way to reduce the amount you owe is to find a loan with a lower interest rate. In the above example, if your loan’s interest rate were only 3%, then your first year’s interest expense on $10,000 of principal would be $300.
If you still made the $1,000 payment after one year, you’d be paying off $300 in interest, and the remaining $700 would go toward paying down your $10,000 principal amount. In the second year of the loan, you would only owe $9,300 in principal, so your second year’s interest payment would be $279 ($9,300 multiplied by 3%).
Fixed vs. Variable Interest Rates
Many student loans – including student loans from the federal government – have fixed interest rates. With fixed rate debt, your interest rate will stay the same over the entire term of your loan unless you refinance your debt. So, if you have a 6% interest rate when you sign your loan papers, you’ll need to pay 6% until you pay off your loan.
The benefit of a fixed rate loan is that you get predictability. You can reliably plan your student loan payments without having to change your plan based on economic conditions or worrying about what the Federal Reserve is doing with interest rates. For many borrowers, the certainty of a fixed rate loan makes sense.
However, some borrowers choose variable rate loans. As the name suggests, variable rate loans can change based on the economy. Many variable rate loans are tied to a specific interest rate index. Standard indexes include the London Interbank Offered Rate (LIBOR) or the Wall Street Journal Prime Rate. Usually, lenders will set the interest rate as a fixed rate above these indexes. For example, your student loan rate could be LIBOR plus 2%.
The benefit of variable interest loans is that you benefit from periods where interest rates are low. For example, let’s say LIBOR is at 5% when you sign the loan, but then it goes down to 2% the next year. Luckily, your student loan interest payments will be much lower than if you had a fixed rate loan.
However, variable rate loans can be risky. You never know when interest rates might spike. For example, in 1990, LIBOR was over 8%. Variable rate student loans have a higher risk and higher reward.
APR for Student Loans
A student loan’s APR is calculated by combining the interest rate with the fees associated with taking out the loan and any capitalized interest. Possible fees include application fees, legal fees, and underwriting fees. One of the most common types of fees are origination fees, which we’ll cover below. Some lenders don’t charge extra fees on student loans. If you don’t need to pay any fees, your loan’s APR is the same as the interest rate.
What Are Origination Fees?
Origination fees are charged by a lender to cover the costs of processing the loan. An origination fee might also be called an administrative, processing, or underwriting fee. Origination fees for government loans are typically between 1% and 5% of the total value of the loan. While some private lenders charge origination fees, most don’t. However, all government student loans carry origination fees, so be extra careful when taking out federally-issued debt. Make sure to do your homework.
How Do Origination Fees Affect Loan Proceeds?
Typically, lenders deduct origination fees when they give you your loan proceeds, which may significantly affect the amount of money you receive. Make sure to consider origination fees if you’re borrowing the exact amount of money for a specific expense like a semester’s tuition.
For example, if you wanted to borrow $10,000, but the lender charges a 4% origination fee, you would only receive $9,600. However, you’ll have to pay interest on the full $10,000 loan.
If you need $10,000, you’ll have to borrow a slightly higher amount to make up for the origination fee. With a 4% origination fee, you’d need a loan of $10,416.66. After applying the 4% fee, you’d receive $10,000 in proceeds. But remember, you’ll have to pay interest on the full $10,416.66.
How Loan Timing Affects APR
Some student loans start accruing interest faster than others. For example, subsidized student loans don’t start accruing interest until six months after the student leaves school — this six-month period is known as the “grace period.”
On the other hand, unsubsidized loans accrue capitalized interest while the student is in school. For example, if you take out a $50,000 loan at 5% interest, you’d owe $56,364.07 by the time you finish four years of college. As a result, even though your interest rate would be the same as a 5% subsidized loan, your APR would end up being higher.
Choosing a Student Loan Based on APR
Because many student loans have origination fees, it’s often helpful to compare loans by APR instead of the interest rate. In some cases, a loan with a higher interest rate might end up being cheaper than a higher-interest loan with a low origination fee. Comparing APRs is a better way to get a side-by-side comparison of your total annual cost.
Let’s illustrate with an example. Say you need a $20,000 loan, which you’ll repay in three years. You have two options for a student loan:
- Option 1: The interest rate is 9%, and the origination fee is $500.
- Option 2: The interest rate is 9.5%, and the origination fee is $100.
If you look at interest rates alone, you might choose option 1. After all, 9% is lower than 9.5%. However, when taking into account origination fees, option 1’s APR is 10.089%. On the other hand, option 2 has an APR of just 9.716%.
Assuming monthly payments, option 1 will cost a total of $25,410.03. Whereas, option 2 costs $25,302.23 over the term of the loan, making it a better financial option.
Focus on Total Repayment
While APR is often helpful when deciding between loans, the best way to choose a product is based on the total cost. In some cases, a longer-term loan with a lower APR might cost you more than a shorter-term loan with a higher APR.
Let’s do one more example to illustrate. Here, we’re going to take out a $25,000 loan.
- Option 3: 10-year loan, interest rate of 6%, and a $1,000 origination fee.
- Option 4: Five-year loan, interest rate of 7%, and a $1,500 origination fee.
Here, option 3’s APR is 6.910%, while option 4’s APR is 9.629%. If you were looking only at APR, option 3 would be the clear winner.
However, because option 3 is a longer-term loan, the total amount you’ll have to pay is over $3,000 more than option 4. While option 3 will cost you $34,306.15, option 4 costs $31,201.80. Try using an APR calculator to play around with different loan options so you can determine which loan will cost the least in the long run.
Get Help With Student Loans
If you or someone you know is in the college selection process, visit College Finance for in-depth resources helping students and parents pay for college. Whether you want to learn about financial aid, student loans, or other financing options, our experts at College Finance can help you plan for the future.