What’s the best student loan for you?
To answer that question, you need knowledge of key financial terms and a common frame of reference. Something that brings logic and order to a world of credit offers whose terms can vary widely.
Congress recognized that need a number of years ago. So it enacted the Truth in Lending Act and developed "Regulation Z," which lenders must follow when advertising consumer credit – including private student loans.
With the information disclosed under "Reg Z" and a working knowledge of some basic lending industry terms, consumers can directly compare competing credit offers and choose the one that makes the most sense for them.
Student Loan Comparison Shopping 101
Here are terms you need to know in order to become an effective comparison shopper for student loans.
- Origination Fee: Most lenders charge an Origination Fee, or "O Fee," on private student loans. This fee, which usually varies depending on the borrower’s credit history, income, and other credit-based criteria selected by the lender, is generally calculated as a percentage of the loan amount. Typically, the O Fee is added to the loan’s principal balance so the borrower need not pay it "out-of-pocket."
- Index: The index is the base interest rate and it is specified in the loan documents a borrower signs. It is not, however, the rate the borrower pays. To get that, a "margin" or "spread" that is specific to each borrower’s situation is added to determine the loan’s overall interest rate. Indices are widely used in financial circles and are not set by lenders. Typically the index used is a published rate such as the Prime rate or LIBOR (see below).
- Prime Rate: The Prime Rate is the interest rate commercial banks charge their most creditworthy or "prime" customers. It is set by each bank, though many banking institutions quote Prime Rates established by the large commercial banks. There is also a Prime Rate published in the Wall Street Journal, which is an average of the Prime Rates of the nation’s largest commercial banks. The Prime Rate is often used as the base rate or "index" on consumer loans. LendingTree Student Loans uses the Prime Rate as its index and updates its rates monthly.
- LIBOR: LIBOR stands for "London Interbank Offered Rate" and is the average interest rate offered by a specific group of London banks on U.S. dollar deposits of varied maturities, similar to the Prime Rate. Student lenders often use either the "one month" or the "three month" LIBOR. Although LIBOR is typically lower than the Prime Rate, that does not necessarily translate into a lower overall cost of credit. You have to consider the "spread" or "margin," the origination fee, and other fees along with this index to determine the total cost of borrowing.
- Margin or Spread: This is a percentage lenders add to the "index," or base rate, to arrive at the overall interest rate. Like the O Fee, the spread or margin on most private student loans is determined by the applicant’s credit history (and the credit history of their co-applicant, if there is one), their income and other credit-based criteria unique to each lender.
- Repayment Fee: A fee that is sometimes charged on loans with total deferment in which there is capitalization of interest at the start of the principal repayment period. This shouldn’t be confused with pre-payment penalties charged on some types of loans when the entire loan is paid off in full before the loan term expires.
Now, one would think that by comparing the "overall interest rate" of two loans, one could determine which loan was less expensive. However, the overall interest rate doesn’t reflect a lot of other items, such as the O Fee and any Repayment Fee. That brings us to APR – the "great equalizer" when it comes to shopping for student loans.
APR, or Annual Percentage Rate.
Why is it "the great equalizer?" Because:
- APR expresses the total effective cost of credit as a yearly rate. It takes account of every penny a borrower is being charged for credit, including a loan’s origination fee, the finance charge and other charges such as "repayment fees" on total deferment loans with capitalization of interest. The APR also takes into account other relevant factors, such as the term of the loan and payment schedules.
- By law, nearly all consumer loans – including student loans – must disclose the APR. So any student loan is going to have this key information disclosed clearly in compliance with Reg Z.
When comparing student loans, make sure you’re looking at each loan’s APR, and not its interest rate, finance charge or the loan’s Index or Spread. This way you will be comparing the total cost of credit on each loan on an "apples to apples" basis. This is the best way to make a fully informed decision.
Truth in Lending Disclosure.
This document – sometimes referred to as the "TIL" – is sent to the borrower(s) prior to or when the first check is disbursed for the loan. It contains four pieces of critical information for the borrower:
- APR: the total effective cost of credit expressed as a yearly rate
- Finance Charge: the dollar amount of interest if the loan is paid over its full term
- Amount Financed: the amount of credit actually available for the borrower’s use, or the net amount of credit extended
- Total of Payments: the sum of the Finance Charge and the Amount Financed.
Lenders may – but aren’t obligated to – disclose additional information in their correspondence with borrowers.
Thanks to Reg Z, you can zero in on APR to do a real "apples to apples" comparison of the cost of every single student loan you’re considering.
If you are still a bit confused about the difference between an index and APR and you’d like additional assistance, give us a toll-free call at 1-866-532-7605. Our Loan Specialists will be happy to help you gain a better understanding of your best education financing options.
Content provided by EduCap, Inc. Copyright 2005 EduCap, Inc. All rights reserved.
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