Interest

Types Of Federal Student Loans

Students who look for financial aid during studies either go for federal student loans or private student loans. Federal student loans are offered by the US government, which are available directly through banks, student loan lenders, schools or from the Federal Family Education Loan program (FFELP). Federal loans are offered with very low interest rates, longer repayment periods and various kinds of repayment options with simpler credit requirements than private loans. In case of federal subsidized student loans, the interest is paid by the government to the financial institution while the student is enrolled as well as during a grace period. A federal loan may not be enough to cover all the expenses of the student and in that case, the student might have to take an additional private student loan. Note that the student will not get the full loan amount applied for and should only take the actual amount into account while preparing the budget.

There are different kinds of federal student loans from different institutions. Hence, it is advisable to take the guidance of parents or other financial aiding sources to decide on the type of federal direct student loan that suits the student the best.

Perkins loan option:

This loan is available for undergraduates and graduates in need at a fixed lower interest rate of five percent for a repayment period of ten years. The loan limits for undergraduates are $5,500 per year and $27,500 per lifetime. For graduate students the limit is $8,000 per year and $60,000 per lifetime (including undergraduate loans). The funds are handled directly by the school, making it easier to get the amount as soon as the student enrolls.

Stafford loan option:

This is the most common federal student loan and anyone can apply for it. It offers fixed interest rates and is available in the subsidized and unsubsidized form. When making use of the subsidized federal student loan, the government pays the interest while the student is enrolled. In the case of unsubsidized federal student loan, the student has to the pay the interest but can wait with payments until he completes his or her graduation. The interest rate for unsubsidized loans is currently at 6.8 %. Students applying for a Stafford Loan must complete the FAFSA (free application for federal student aid). Stafford Loans are available directly from the United States Department of Education through the Federal Direct Student Loan Program (FDSLP). It is important to apply much earlier than the closing date for the application to avoid any last minute trouble.

PLUS loan option:

Also known as parent loan for undergraduate students. It is given to the parents of undergraduate students who are dependent and have enrolled at least half-time. This loan option requires the applicant to be free from any adverse credit experiences like bankruptcy, default etc on their credit record. These loans are offered at a fixed interest rate that is higher than the Stafford loan rate and repayment starts while the student is enrolled.

For more information on student loans check out my post about Student Loan Consolidation.

From Simple to Compound Interest

Imagine you loan a bank the principal P = 10000 $ at an interest rate of i = 5 %. This is the amount of interest you would receive with simple interest, given the duration t of the loan:

t = 1 year
→ I = 10000 $ * 0.05 * 1 = 500 $

t = 2 years
→ I = 10000 $ * 0.05 * 2 = 1000 $

t = 3 years
→ I = 10000 $ * 0.05 * 3 = 1500 $

As you can see, the interest grows linearly with the duration of the loan. For each additional year, you get an additional 500 $, which is just 5 % of the principal 10000 $. In other words: each year the interest rate is applied to the principal. How could that be any different?

Consider this: At the end of the first year, you’ll receive an interest payment in the amount of 500 $. This means that your bank statement will now read 10000 $ + 500 $  = 10500 $. So why not apply the interest rate to this updated value? This would lead to an interest payment of 10500 $ * 0.05 = 525 $ for the second year instead of just 500 $.

Continuing this train of thought, at the end of the second year your bank statement would read 10000 $ + 500 $ + 525 $ = 11025 $. Again we would rather have the interest rate applied to this updated value instead of the unchanging principal. This would result in an interest payment of 11025 $ * 0.05 = 551.25 $ for the third year.

For comparison, here’s what the final pay out would be for the simple interest plan:

10000 $ + 500 $ + 500 $ + 500 $ = 11500 $

And this is what we would get with the “not simple” interest plan, where we apply the interest rate to the updated amounts instead of the principal:

10000 $ + 500 $ + 525 $ + 551.25 $ = 11576.25 $

The latter is called compound interest. It means that we include already paid interests in the calculation of next year’s interest, which leads to the amount received growing exponentially instead of linearly.

(This was an excerpt from “Business Math Basics – Practical and Simple”. You can get it here: http://www.amazon.com/Business-Math-Basics-Practical-Simple-ebook/dp/B00FXB8QSO/)