Understanding any kind of loan – not just student loans – starts with understanding three key pieces of information:
Some of the most common types of loans people take out are home loans (i.e. loans to help pay for a house) and auto loans (i.e. to help pay for a car.) Therefore, when talking about these types of loans, you might here people say something like:
“I borrowed $10,000 at 8% over 15 years.” In this case:
Let’s take a look at how you can use this information to understand what you really care about – how much you have to pay! A full discussion on all the details of interest rates can get complicated, but let’s use a simple example using the loan above to illustrate how it works in general.
In our example, let’s say you pay interest once a year. In this case, when you have an interest rate such as the 8% above, it means that if you borrowed $100 today and paid it back in a year, you’d owe $108 – that is, you’d owe $8 in interest. How did we figure out that you’d owe $8 in interest? We get that by multiplying the amount you owed at the start of the year – this is called the starting balance (in this case $10,000) – and multiplying this by the interest rate (in this case 8%). In other words, $10,000 x 8% = $800. (Remember that 8% is equivalent to 8/100 or 0.08, so you can multiply $10,000 x 0.08.)
The main thing to remember is that, in general: the higher the interest rate, the more expensive the loan.
(So if you take out loans, you generally want ones with lower-interest rates.)
You may have noticed above that we originally called the $10,000 the principle, but now we just called it the starting balance. This isn’t to confuse you. The reason is that that the loan in our example has a term of 15 years, not just one year! Let’s say you took out the loan of $10,000 on January 1, 2014. A year later – say on December 31, 2014, you would be charged interest, and that interest would be added to your balance, like this:
As you can see, the starting balance refers to the balance for the period, or the amount of time over which you are charged interest. In this case the period is a year. The interest is then added to your balance, and – and this is very important – in the future, interest is calculated based upon the new balance, not the original principal! This is known as compounding interest. Take at the example above again to make sure you understand what’s going on.
The other common type of interest is known as simple interest. When a loan has simple interest, the amount of interest paid in each period is the interest rate times the principal (i.e. the original loan amount, not the new, updated balance.) In the example above, if the loan had been simple interest, the amount of interest in each period would have always been $800 (i.e. $10,000 in principal x .08 interest rate = $800 in interest).
As you can see, the amount of interest – and eventually the total amount you owe – is higher in the case of compound interest. The effect of compounding interest cannot be overstated, so make sure you understand it. To illustrate the difference, let’s say take our example above, but instead of it being a 15 year loan, let’s extend it to be a 30 year one instead. For the sake of simplicity, we’ll assume you weren’t making any payments on your loan until the end of the 30 year period, so we can just focus on the total amount you’d owe:
In this example, at the end of 30 years of simple interest, you’d owe $34,000 on a $10,000 original loan. However – just by switching to compound interest – you’d owe over $93,000! As you can see, the type of interest on a loan can make a BIG difference, so when comparing loans you cannot only look at the interest rate, you also need to make sure what kind interest you are paying.
Unfortunately for loans, the complexity doesn’t stop there. Remember how in our example above we assumed that the amount of interest due was calculated once a year? Well, it turns out that loans can also vary in terms of when (or over what period) they calculate interest too! For example, many loans calculate interest due once a month, but some could do it twice a year, every week, or – like many credit cards – every single day!
Why do they do this? To make more money! To better understand how it makes them more money, let’s again take our above example, but only look at the first year. In our original example, you borrowed $10,000 at 8% interest, and we assumed that the amount of interest owed was calculated once a year, so at the end of the year, the calculation we did was $10,000 x .08 = $800 in interest.
Now let’s take see what would happen in the case – assuming compound interest – what would happen if, instead of calculating the interest owed once a year, we calculated it once a month?
Let’s just take the first 3 months:
Woah! Wait a second – this can’t be right: the amount you owe is going up so quickly! Surely that can’t be right! Well, sort of… you see, when we specified that the interest rate was 8%, we never specified over what period we were calculating the interest… and as you can see, calculating interest once every month leads do a very different cost than calculating it once a year! The period matters.
Okay, so let’s try something a bit more reasonable. Most of the time when you see interest rates on loans, you see what’s called the Annual Percentage Rate, or A.P.R. You may have seen this on car commercials, where they’ll say something like “Get new car financing with $0 down and only 4.5% APR.” Sound familiar? That’s the same APR we’re talking about here.
Take the time to understand how interest works, and you’ll understand one of the single most important things you can know for ensuring you’ll always have money.
Okay, so back to our example: let’s say what we really meant when we said the interest was 8% was 8% APR and that interest was calculated each month. Since we know the annual rate is 8%, to get the monthly rate, we divide 0.08 by 12, and get 0.8/12 = .06667 or 0.667% interest per month. So now let’s try our calculations again…
Much better. But wait! If you’re paying close attention, you’ll notice something strange. Look at the final ending balance we calculated in the table above: $10,830. Now compare that to the the first table we used where we were calculating the interest once a year, and look at the balance for 2014 there: 10,800 – there’s a $30 difference! What’s going on?
The answer is that loan companies and banks are trying to confuse you again. You see, the APR is really a misleading number, because it doesn’t really mean what you’d expect it to mean: what you’d expect it to mean is that if you multiply the starting balance at the beginning of the year by the APR (to get the amount of interest owed) and then add that to the starting balance, you’d get ending balance that you owed at the end of the year. In other words, you’d expect the following calculation to be true:[Starting Balance for Year] * [APR] + [Starting Balance for Year] = [Final Balance for Year]
But you’d be wrong! The APR is actually defined as follows: the periodic interest rate times the number of calculation periods in a year. In other words:[APR] = [Periodic Interest Rate] x [Number of Calculation Periods in a Year]
Okay, so if that’s true, then when we calculated the Periodic Interest Rate (i.e. [APR] / [Number of Calculation Periods per Year]) to be 0.667%, we did the right calculation based upon the definition. So why don’t our year-end numbers match?
The reason is that what we were looking for (what we’ll call X in the following equation):[Starting Balance for Year] * [X] + [Starting Balance for Year] = [Final Balance for Year]
X isn’t APR…X is what is called the Effective Annual Rate (EAR), or Effective APR. In other words, is the number you would actually think of as the “true” annual interest rate.
Okay, fine. So then the real question becomes: how do we use the APR to calculate the EAR?
Let’s start with our example, where our APR was 8%, giving us a periodic interest rate of 0.667% and a final ending balance of $10,830 – what is the EAR there?
To calculate this, we are basically asking to solve for EAR in the following equation:[$10,000] * [EAR] + [$10,000] = [$10,830]
So, in this example, although the APR was 8%, the EAR was actually 8.30%! You can see how the APR can be misleading.
In general, given a loans APR and any fees, you can calculate a loans EAR as follows:Periodic Rate = APR / # Calculation Periods per Year
As if things weren’t complicated enough, all the above doesn’t even include the fees that many lenders will charge you for giving you the loan in the first place! The calculations required to figure out the EAR when fees are included are beyond the current level of this article, but the point is that you should be aware of them, since they can significantly affect the overall cost of the loan!The point of these two examples is that, with traditional loans, the true cost of a loan – as well as how much you have to pay – is not easy to understand right away, and often banks or traditional lenders don’t have much incentive to explain it to you.
Okay, so now you have a good understanding of how interest rates work…or at least realize that they not nearly as straightforward as they might seem at first. So the next question is – how does a bank decide what interest rate to charge your, or if to give you a loan at all?
The short version is that – at least for private loans (federal student loans are different) – lenders typically look at the credit score of you and/or your parents. A full explanation of how credit scores are calculated are more than we can go into here, but very broadly speaking they are based upon criteria including:
This is often fine for loans like home and auto loans after you have had a chance to build up a credit history, but often penalizes students (who don’t have much of a credit history), or keeps students from getting needed loans because their parents have little or bad credit.
Your credit score (or the scores of your parents) are usually used to determine if you’ll get a loan, and – if you are able to get one – what rate you’ll pay. The worse the credit score, the higher the rate.
The other thing to be aware of about interest rates is that they can be fixed or variable. When a loan has a fixed interest rate, that means that the interest rate is the same through the life of the loan. However, some loans – notably most private student loans – have variable interest rates, which means that the interest rate can change over the life of the loan based upon external factors. This can make it very difficult to predict how much interest you’ll have to pay in the future.
The general rule of thumb should be that – especially for long-term loans like student loans – you should only take fixed interest rate loans.
When someone takes out a loan – whether for school, a house, a car, or even when they use a credit card (which is basically a kind of short-term loan), they are using something call debt. Debt (i.e. loans) have been around for a long time, because they are valuable: if you are a farmer and need to buy a new tractor to plough your fields but don’t have the money available to buy one, you can get a loan, buy the tractor, and then pay back the lender with the money you get from selling your harvest. You’re better off because you got to produce your crop, and the lender is better off because you paid back all the money you owed, plus some extra – the interest – in exchange for them letting you borrow the money.
However, lending money has risks for the lender, too. If you were to buy the tractor and then not plough the field, or if you planted but the harvest wasn’t good that year and you couldn’t afford to pay the lender back, they would have lost money. To protect themselves in these scenarios, lenders often require what is known as collateral – something of value that you agree to allow the lender to take in the event you can’t pay the loan back with interest. In this example, the collateral would likely be the tractor, but the same applies to houses (a mortgage is actually an agreement between the homeowner and the bank that treats the home as collateral for the loan), autos, factories, and many other things.
With student loans, however, it’s a bit tricker – what collateral does a student have? The bank can’t “take” the knowledge you’ve learned out of your head and sell it! Because of this, student loan companies have convinced politicians to make student loans special by adding some distinct features.
You see, with most other loans, you can be absolved of your obligations if you do something called filing for bankruptcy. Bankruptcy is when you make your case to the government that you are in such poor financial condition that you have no money left to pay your debts, and ask to have your debts forgiven (i.e. removed). That may sound like a great thing, but it’s not – if you file for bankruptcy, the government or lenders will often take almost everything you own and your ability to ever get any type of loan again (including credit cards) will be severely restricted. The take away is you don’t want ever to have to file for bankruptcy, but if things really got so bad that that is the best option – at least there is some way out of owing your debts (otherwise, you would go to jail.)
However, with student loans, because there is no collateral, lenders have convinced lawmakers to make student loans non-dischargable in bankruptcy.
This means that – unlike almost any other loan type – student loans are NOT forgiven
even if you file for bankruptcy – they will follow you forever.
This sounds really scary, and it kind of is. But this does not mean all student loans are bad or that you should avoid them entirely – it just means that you need to understand what you’re getting yourself into and exercise caution and good judgement before agreeing to take them on.
If you weren’t already asking yourself this question before reading this, by now you’re almost certainly asking yourself:
Is taking on all this student debt worth it?
It’s a great question, and something we don’t feel that is talked about enough (though it is getting more and more attention lately, which we think is great!) Our answer is in general yes, but you need to understand what you’re getting for what you’re giving. Knowing the answer to this question really means answering three questions:
In our view then, there are four problems with typical student loans: