One of the best ways to start out on a solid financial path after college is to choose the right type of loan while you’re still in college.
The new student loan debt statistics are unnerving. The amount owed on all student loans in the U.S. is $1.3 trillion. Students from the class of 2016 graduated with an average of $37,172 in loan debt.
All the information on Perkins Loans, PLUS Loans, and Direct Subsidized and Unsubsidized Loans can become confusing. How do you control how much money you borrow?
The best solution is to apply for grants and scholarships throughout college and to choose loans that won’t leave you struggling afterwards. Knowing the difference between a Direct Subsidized Loan and a Direct Unsubsidized Loan could save you money so that you have less to repay after you graduate.
Your FAFSA package will contain the details on what kind of loans your school will offer, but it makes sense to do your research before you sign a promissory note.
By the time you finish reading this article, you’ll know all about the similarities and differences between subsidized and unsubsidized loans, to make it easier to understand your financial aid package. First, we’ll talk about the similarities, and then we’ll discuss the differences and look at an example.
What Do Subsidized and Unsubsidized Loans Have in Common?
Subsidized and Unsubsidized loans have many things in common. Here’s a list of three major similarities:
Same Federal Interest Rates. Both loans carry the same rate. The rates vary from year to year, but it’s 4.45% for undergrads for the 2017-18 school year. New rates are set each spring before the new school year begins.
Both Have a Promissory Note. This is your promise to pay by a specified date.
Same Loan Fees. The fees for both loans are the same and are 1.069% for 2017.
What is the Difference Between a Subsidized and Unsubsidized Loan?
There’s only one difference, but it’s big and can add up to a significant amount if you’re not careful. The difference is the interest and whether the government pays it for you. Here are the details:
The interest is added on to the principal balance of the loan from day one and continues accruing during school years, grace period, and afterward, until the loan is paid in full.
Interest on the unsubsidized loan begins accruing on the issue date and then compounds for the life of the loan. This type of interest is known as capitalized interest. It’s more complicated than just multiplying the loan amount by the interest rate.
To understand how capitalized interest works, let’s say you take out a loan for $10,000 at a 5% interest rate. Here’s what would happen over a period of four years and note how the principal loan amount grows:
Principal Balance: $10,000
Year 1: $10,000 loan amount x 5% interest rate = $500 in interest
Year 2: $10,500 loan amount x 5% interest rate = $525 in interest
Year 3: $11,025 loan amount x 5% interest rate = $551.25 in interest
Year 4: $11,576.25 loan amount x 5% interest rate = $578.81 in interest
New Principal Balance: $12,155.06
Do you see how compound interest adds up? By the end of four years, $2155.06 would have been added onto the loan.
You can probably see how difficult it would become to pay off your unsubsidized loan after several years of capitalized interest, especially if you defer your loan to go to graduate school. By the time ten years pass, you will have owed or paid thousands more than the original loan amount. Keep reading to find out about subsidized loans.
The scenario is much simpler if your loans are subsidized. The government pays the interest on the loan while you’re in school at least part-time, while your loans are in deferment, or while you are in the grace period. The grace period lasts for the six months after you stop attending school or after your enrollment dips below part-time.
All the accrued interest you see in the Unsubsidized Loan example would have been paid by the government.
See the difference? The best way to avoid compounded interest is not to take an unsubsidized loan. Search for scholarships and grants throughout your school years, and get a work-study job. If these are not options, your second-best bet is to pay the interest each year on your unsubsidized loan so that it is not added on to the principal loan amount.
Remember, interest begins accruing from the first day your school loans you the money. You will get a statement of accrued interest in the mail each year. While it’s technically not a bill, you can still use it as a prompt to pay.
Are you in school with student loans or graduated and working on a plan to repay? What has been your experience with getting a subsidized or unsubsidized loan?