When it comes to student loans, most people are curiously uncurious about the interest rate they’re being offered. It makes sense to some extent — after all, federal loans, which make up the majority of outstanding education debt, only offer one interest rate for each type of loan (e.g., 7.21% for Direct PLUS loans, regardless of the borrower’s creditworthiness). People usually take the rate they’re given and don’t think twice about it.
But as the interest rate environment changes and new student loan options (like refinancing) become available, it’s increasingly important for borrowers to get acquainted with their interest rate(s). For example, one of the best questions I hear from our members here at SoFi (a lender that offers student loan refinancing) is what is the difference between straight interest rate and annual percentage rate (APR) – and why should they care?
Since interest rate is directly associated with how much money you’ll spend paying back your debt, it’s important to understand how these terms differ as well as how they relate to student loans specifically. Here’s a quick primer.
Interest rate is basically the amount your lender is charging you to borrow money. It’s expressed as a percentage of your principal (or original loan amount) and doesn’t reflect any fees or other charges that may be connected to your loan.
APR, or the annual percentage rate, represents a more complete view of what you’re being charged. Since fees are factored in, it’s almost always higher than the interest rate. Government regulators require lenders to disclose APR to prospective borrowers, which theoretically makes it easier for you to determine the true cost of one loan versus another.
For student loans, the most common fee is the origination fee, which is basically an upfront charge that lenders – private and federal – may charge for originating, or making, the loan. It can vary widely from one lender to the next, and some loans may not even have one at all.
While the idea behind APR is that it should provide a more apples-to-apples comparison of loan costs, lenders can handle origination fees in different ways, which can in turn affect what’s included in APR. For example, federal student loans deduct the origination fee from your loan disbursement upfront, which keeps the fee out of the APR calculation. Private lenders typically add the origination fee to the loan amount and “finance” it, which means it is included in APR.
Borrowers should also be mindful of the time that the loan spends in forbearance — if interest is accrued during the time of non-payment, that interest is capitalized (i.e. added to the loan’s principal) when repayment begins or resumes. APR on a new loan won’t reflect this cost because it’s a variable that has yet to occur (and may not at all). Just know that if you do take advantage of forbearance options, it is likely to affect your APR.
The Bottom Line
As with any type of debt, it’s important to understand the costs associated with your student loans. If you’re concerned about how much interest you’ll be paying (as is often case in refinancing situations), you should look at both the interest rate and APR, and ask the lender about any charges that may be unaccounted for in these figures.
Making your student loan payments more affordable can help you manage your debts better over time. Staying on top of your student loan payments can help you build or maintain good credit, too. You can see how your student loan payments are affecting your credit by getting your free credit report summary, updated every month, on Credit.com.
More on Student Loans:
- How Student Loans Can Impact Your Credit
- Can You Get Your Student Loans Forgiven?
- Strategies for Paying Off Student Loan Debt