Understanding the True Cost of Student Loans

Jul 09, 2019
Student loans, Income-share agreements

Working with student loans can be a stressful and difficult process, especially when it comes to understanding the actual cost of everything involved. It may look reasonable initially - borrow money, then pay it back - but there are actually more than a few potential complications along the way. Like an iceberg, many of the hazards involved in taking out a loan are under the surface.

There are several factors involved in determining interest, both at the time of taking out the loan and while paying it back. Both federal and private lenders are affected by these factors in various ways. If you’re in the process of repaying your loan while still in school, then a lot of the information below could be helpful.

Interest rates at origination for federal loans  are determined by the Department of Education and passed into law by Congress on a yearly basis. The rates they pass are based on 10-year Treasury notes, plus a fixed increase. While the exact interest rate depends on the type of loan, all are dependent on the disbursement date when federal funding is granted to a student or paid directly. For example, if you’re an undergraduate student who took out a subsidized (or unsubsidized) federal direct loan between  July 1st, 2018 and July 1st, 2019 you would pay a fixed rate of 5.05%. Current federal student loan rates can be found at the official Education Department site here.

There are caps on maximum interest rates for federal loans, but the caps do not incorporate possible additional cost from accrual and capitalization of interest - more on this below .

Obtaining a loan from a private lender relies on additional financial criteria. In particular, both your interest rate and your eligibility for getting a loan will likely depend on having a good credit history or a willing and able cosigner. Another factor that will determine your interest rate is the length of the repayment period chosen for the loan. Consequently, getting approved for a private loan can be much less predictable than applying for federal aid.

If you aren’t able to pay your interest while you are in school, the principal balance increases over time, starting on your disbursement date (your disbursement date is the day the lender sends funds to you or your school). This is called accrual, and it continues until you start making minimum interest payments. The additional capitalized (i.e., unpaid interest added to principal) account can make it more difficult to make future payments by increasing your principal balance and maturity.

This is how accrual and capitalization works: once you graduate, your interest capitalizes for the first time, which means that any unpaid interest will be added to the principal balance. If you make your monthly payments on time, the portion of your payment that goes towards repaying the principal balance will increase, and the portion dedicated to paying interest will decrease. If you aren’t able to repay the interest portion of your monthly payments, the lender will capitalize the loan again, adding that month’s unpaid interest to your principal balance. In addition, unpaid months increase the length of the loan. Both federal and private lenders handle accrual in the same way. This is how your principal balance can keep increasing while you’re still making payments, and why many people end up taking far more time than they expected to pay off their loans.

Income share agreements (ISA) are an alternative to the standard loan process, and can be a more accessible way for students to pay for college without having to deal with the difficulties that come with handling accrual and capitalization on top of a regular student loan. An educational income share agreement is an arrangement where a student pays back a percentage of their future income for a fixed term. The terms of the ISA require that payments must be made for a certain number of months, or possibly up to a maximum cap level of total payment. Payments are paused or are forgiven if income falls below a minimum threshold. 

The MentorWorks ISA model provides ISA financing to students and provides them with opportunities to connect with corporate recruiters, who we invite to hire students from our platform. With our support, funded students get ISA payment discounts to support the next generation of students as career advisors and referrals.

With MentorWorks, you pay it forward.

For more information about MentorWorks and how we work, feel free to read about what we can offer at mentorworks.io.

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About the Author

Hayley Long

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