Borrowing money to pay for college or other postsecondary education is often the first encounter that many people have with any type of financial product or loan. Novice borrowers are likely to encounter a number of new financial terms, and it may even feel at times like the financial aid administrator or lender is speaking another language.
This quick reference guide defines some of the most common student financial aid terms that you should know before you borrow student loans. It will also help you understand the ways in which some seemingly related terms have key differences that are not always obvious.
Annual Percentage Rate, Interest Rate. Annual percentage rate, commonly called APR, and interest rate are both ways of expressing the cost of a loan as a percentage. However, interest rate conveys the cost of borrowing the principal amount, while an APR conveys the annual cost of a loan including any associated charges or fees.
The cost of all federal student loans is expressed as an interest rate, which means it does not include the origination fees that are charged on federal student loans. Typically, private lenders provide an APR, which will include any fees charged by the lender. This can sometimes make it hard to compare the two, but the first step is understanding this key difference.
Capitalization. Capitalization occurs when any unpaid interest that has accrued is added to the principal balance of a loan. Interest may be capitalized when your student loans enter repayment or when you change repayment plans. Unpaid interest can also be capitalized when you miss one or more payments or at the end of a deferment, forbearance or grace period.
After unpaid interest is capitalized, interest payments will be calculated using the new, higher principal loan balance.
Consolidation, Refinance. Student loans are a form of nonrevolving credit, which means that you take out a new loan each year you need to borrow. As a result, you can have several different student loans when you graduate. Consolidation and refinance are options that can sometimes help borrowers better manage repayment by taking out one new loan that pays off the original loans.
When you refinance, you take out a new loan with a new interest rate based on your current credit score, income and other factors. This interest rate is not based on the interest rates of your current loan, but you can save money if you are able to get a lower interest rate on the new refinancing loan.
Consolidation combines your loans into one new loan with an interest rate that for federal student loan borrowers is an average of the interest rates on the student loans being consolidated, rounded up to the nearest one-eighth of a percentage point. Consolidating private student loans could save you money as well.
Consolidation and refinance are both big decisions for many reasons, and neither option is right for everyone. Consider the pros and cons carefully, as you may lose some benefits of the original loans in taking either route.
Deferment, Forbearance. Deferment and forbearance are tools that can provide temporary relief for borrowers who are struggling to make student loan payments. Both options allow borrowers to suspend their payments for a period of time in documented cases of financial hardship or for medical reasons, for example. Federal student loan payments can also be deferred if a borrower attends an eligible college or career school at least half time.
In most cases, interest continues to accrue during a period of deferment or forbearance, which means your balance will increase and you may end up paying more over the life of your loan. The key difference is that in some cases, student loans in deferment do not accrue interest while those in forbearance do. Always check with your lender or federal student loan servicer to be sure.
Delinquency, Default. Once student loans enter repayment, borrowers are obligated to make monthly payments on time. When payments are missed, loans go first into delinquency and may later enter default, both of which can carry negative consequences.
A student loan becomes delinquent on the first day that a payment is missed. You can think of delinquency as a warning sign to make payments on time or to reach out to the lender or loan servicer for help. A delinquent loan can be reported to credit agencies at any time, so it’s best to address the situation as soon as possible.
If your loan continues to be delinquent, it will eventually go into default. A default can have a huge impact on your future ability to borrower and can lead to other legal and financial consequences.
Income-Driven Repayment. When a loan is in an income-driven repayment plan, the total amount that is owed each month is based on the borrower’s income and other factors like family size.
This is different from standard repayment, which guarantees that a loan will be paid off in a set number of years by scheduling monthly payments that remain the same each month. Income-driven repayment can lower the amount that you pay each month, but it can cause you to pay more over time by extending the life of the loan.
Most federal student loans — and some private student loans — are eligible for some type of income-driven repayment plan. If you have trouble making your monthly payments, reach out to your lender or loan servicer to talk about available options.
Negative Amortization. Amortization is the process of repaying an installment loan, such as a student loan, through regular payments. When a student loan is amortized, part of the monthly payment is applied to interest and part is applied to reduce the principal balance.
If your monthly student loan payments are lower than the amount of interest that accrues, any unpaid interest may capitalize and be added to the principal amount. This is called negative amortization and can cause the total amount that you owe on your student loan to increase over time — even while you are making monthly payments.
Always pay the full amount of student loan interest that you owe each month, if possible, to avoid negative amortization.
Principal. Principal is the total amount that you borrowed plus any interest that has been capitalized. Interest is calculated as a percentage of the principal amount.
Promissory Note. A promissory note is the contract that you sign with your lender when you take out a student loan. It contains detailed information about the terms and conditions of your loan and your rights and responsibilities as a borrower, so you should read it carefully before signing.
Subsidized Loan. A subsidized loan is a type of federal direct loan that is available to undergraduate students with demonstrated financial need and has slightly better terms than the federal direct unsubsidized loan. The federal government pays the interest on a subsidized loan if it is in deferment, including when the borrower is in school at least half time, and during the six-month grace period after the student leaves school.
Most student loans are not subsidized, which means that a borrower is responsible for any unpaid interest during a period of in-school deferment. This interest is capitalized when the loan enters repayment.
Familiarizing yourself with the terms on this list can help you better understand key financial concepts about borrowing for college and can help you make informed decisions that lead to a bright financial future.
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14 Terms You Need to Know Before Repaying Your Student Loans originally appeared on usnews.com