The reality for many college students is that loans are a necessity if you need additional funding to help pay for school. When choosing loans, it’s important to understand what the loan will really cost you — and how to calculate the true cost of your loan.

Going in with knowledge can help you make better choices about your loans and reduce what you end up paying over time.

How to Calculate Effective Interest Rate

When choosing a student loan, one of the first features students and parents consider is the interest rate. However, it’s important to understand that the interest rate you see might vary slightly from the actual interest rate you pay because of compounding interest.

To calculate your effective interest rate, you can use the following formula:

R (effective interest rate) = (1 + i (stated interest rate)/n (number of compounding periods))^{n – 1}

Many student loan rates are compounded daily. Unless you have a Direct Subsidized loan, the interest begins accruing once the loan is disbursed. So, if you get a student loan for $5,500 at 5.5% APR, and you assume that you’ll have it for 14 years (time in school plus repayment payment), the effective interest rate will be higher.

R = (1 + 5.5/5,110)^5,110 – 1 = 5.65%

You pay more in interest than you might have anticipated. In fact, College Ave Student Loans Chief Marketing Officer Angela Colatriano points out, one way to save on interest is to make payments while you’re in school. Even $25 a month can save you money in the long run.

What’s the True Cost of Your Student Loan?

It’s not just about your interest rate, though. Some student loans come with origination fees. Consider a Parent PLUS loan from the federal government. For example, the origination fee for loans disbursed on or after October 1 2020 is 4.228% of the loan amount.

So, if you borrow $6,000 to help your child pay for school, you’ll also pay an origination fee of $253.68. That amount is added to the cost of your loan — and you end up paying interest on it. As a result, the true cost of your loan is higher.

All federal loans come with origination fees, though many private lenders don’t charge origination fees. Plus, you will pay less over time if you choose an in-school payment plan. Using the undergraduate calculator from College Ave, it’s possible to compare your options.

Let’s say you want to borrow $10,000. There are a couple scenarios you can compare.

If you pay nothing while in school, and repay the loan 10 years after finishing, you might get a variable interest rate of 9.73%. Your total cost for the loan would be $22,544.36.

But what if you decided to make payments of $71 a month while in school. Now, you can get a rate of 8.53% and your total cost for the loan would be $18,736.04. That’s a total savings of $3,808.32.

There are other student loan calculators that can help you figure out the true cost of federal loans, so you can compare them to private loans. Additionally, using calculators to estimate your federal loan costs can also help you determine whether you should make interest payments while in school.

Student Loan Capitalization

One thing to keep in mind is the fact that, when you don’t pay your student loans while in school, the interest adds up and is tacked on. Private loans often use daily compounding, as described above.

Federal loans, though, operate with simple interest, which means you’re just charged interest on the total amount.

In either case, though, the interest that accrues during your time in school is taken, after you graduate, and added to the loan total. This is called capitalization. So whatever interest isn’t paid in school is added to your loan balance at the end of your grace period and you’ll be charged interest on that amount.

Paying interest while you’re in school can reduce the overall cost, since you won’t have any interest to capitalize and add to the loan balance.

Federal Loan Features

“Federal loans often come with unique benefits,” says Colatriano. “They are funded by the federal government and to access these loan options you need to fill out the FAFSA each year.”

Some of the unique features of federal loans include:

• Direct Subsidized loans don’t accrue interest while in school: If you qualify for these need-based loans, you won’t have to worry about the interest accrued in school, potentially saving you money in the long run.
• Public service loan forgiveness: The government offers special forgiveness programs for those who go into certain professions. You can get Public Service Loan Forgiveness, to help with loans when you’re a healthcare professional.
• Extended deferment: You might also qualify for extended deferment for a period of time longer than you might see with private loans.
• Income-driven repayment: There are different repayment options, based on your income, available with federal loans.

These features make federal loans a great first option if you’re considering financing college. However, it’s important to carefully consider your future career path to see whether these loans can be repaid.

Private Student Loan Features

“Private student loans are one option to consider if you need additional funding after federal loans in the student’s name,” says Colatriano. “Since federal loans have annual limits, looking to private loans is one way to fill any remaining funding gap.”

Some of the features you might see with private loans include:

• Fixed or variable rates: Typically, you only get fixed rates with federal loans. However, you have the option to choose between fixed or variable rates with private loans.
• Deferred or in-school payments: You can choose to defer payments until you finish school, or make payments while in school. Options include $25 monthly payments, interest-only payments, or full principal and interest payments, so you can pay less interest than deferred payments.
• Higher borrowing limits: In general, you can borrow up to the cost of attendance minus any other financial aid.
• Some borrowers find lower rates: In some cases, you might end up qualifying for a lower interest rate than federal PLUS loans if you (or your cosigner) have good credit.

Many student loan lenders feature flexible repayment options and term lengths so that you can find a loan that fits your budget.

Bottom Line

No matter what you choose, it’s important to have a good idea of what your student loan is really going to cost.

To reduce what you owe over time, Angela suggests that you start by exhausting scholarships and grant opportunities, and then look at federal student loans in the student’s name.

“If you find you still fall short, one option to consider is private student loans,” she says. “Look for loans with low rates, no origination fees, and a flexible repayment plan that meets your family’s budget.”

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