Grads Take an Interest in Student Loans How to understand and navigate the complex machinations and computations that go beyond principal.

by Anne O’ Dell / Amy Wong

In determining the rate of interest for a privately guaranteed student loan, such as EdFed’s Tuition Loan, lenders use a dizzying array of factors. A potential borrower’s credit history, international banking trends, and corporate loans held by national banks are all deciding factors in just how much actual payments will exceed the principal of a student loan.

Over time, student loans—especially unconsolidated ones—can easily add up to double the principal in payments. Consolidation and a quick repayment schedule can help borrowers beat the system, but everyone who holds student loans should be aware of the risks they run where interest rates are involved.

Read on for an in-depth look at how interest rates are derived and how they affect your loan principal.

LIBOR Index

LIBOR, also known as the London Interbank Offered Rate, is the interest rate at which banks borrow money from other banks in the London Interbank Market. It is also the standard financial index used in U.S. capital markets, including for many privately guaranteed student loans.

Because London’s euro-based market reflects the world economic condition, international investors use the LIBOR interest rate to match the cost of lending to the cost of funds. Many adjustable-rate financial instruments such as Adjustable Rate Mortgages (ARMS) and other variable-rate loans base their interest rates on the LIBOR Index. It is the basis for some of the world’s most active interest rate markets.

The LIBOR Index is set by the independent organization British Bankers Association (BBA), and is an average of inter-bank deposit rates offered by selected London banks for maturities. These rates are applicable to the U.S. dollar, the U.K. pound, the Swiss franc, the Canadian dollar, the Japanese yen, and the Danish krone. In a single month, the BBA fixes hundreds of LIBOR rates in different currencies.

These rates are compiled each working day by an electronic vendor and are then broadcast by various international distribution networks. The LIBOR Index, often used to set loan interest rates in the U.S., is posted daily in the Wall Street Journal.

Prime Rate

One of the most desirable interest rates is called the prime rate. Banks offer the prime rate to their most creditworthy customers, including many student loan borrowers. Unlike the LIBOR Index, the prime rate is not adjusted on a regular basis. However, when the prime rate is adjusted; the LIBOR Index generally has smaller changes than the prime rate.

The Wall Street Journal Prime Rate is the most standard prime rate index. The Wall Street Journal prints a composite prime-rate change only when 23 of the 30 largest banks change their prime rates.

According to the Wall Street Journal, prime rate is the “base rate on corporate loans posted by at least 75 percent of the nation’s 30 largest banks.” Prime rates are usually three percentage points higher than the Federal Funds Rate, the interest rate that banks charge one another.

The Federal Reserve fixes the Federal Funds Rate, increasing it to slow down the economy and lowering it in order to boost the economy. When the Federal Reserve changes the interest rates, the prime rate will also reflect these changes.

However, most corporate loans are indexed to LIBOR. Prime rates, though they are supposed to be 3% higher than the Federal Funds Rate, are almost always equal to LIBOR rates.

When giving loans, banks offer their consumers a rate determined by the sum of three factors: the prime rate; a variable percentage, which is determined by the lender’s assessment of the risk in lending; and the loan’s profit margin.

Prime rates and LIBOR rates greatly affect the interest rates of consumer loan products such as credit cards, home equity loans, auto loans, small business loans, personal loans, some private student loans, and other variable-rate loans.

When a person borrows a loan, banks usually charge compound interest, which means that interest is calculated over the interest that has been added to the debt before. The frequency of compounding directly affects the total amount of interest paid over the life of the loan.

When a student borrows a loan with a LIBOR index, she can choose the frequency of the compounding—whether it is one month, six months, one year, or more. If a borrower has a one-month LIBOR rate, then the interest rate is fixed for that one-month period and compounded once every subsequent month.

To illustrate how this works, let’s take a look at a specific scenario. If a student took out a $100,000 student loan with a one-year LIBOR rate and planned to pay toff her loans after 15 years, she could calculate the total amount paid by using the following compounding formula:

A(t) = A_{0}(1+r/n)^{n-t}

Given that Ao is the principal amount borrowed, which is $100,000; that r is the interest rate, which is currently 5.2476%; that n is the number of compounding periods per year, which is one; and n·t is the total number of compounding periods, which is 15, A(t), the total amount after 15 years, will be $215,368.91.

Let’s look at another example, where the student has a six-month LIBOR rate for a $100,000 loan. The interest rate is 5.1196%. The number of compounding periods per year is two, and the total number of compounding periods within 15 years is 30. Using the same compound formula, the total amount after a 15-year period will be $213,459.

How Borrowers Can Benefit

Obviously, consolidating loans at a single, low rate of interest and paying off student debt quickly are desirable ways to reduce the amount of interest a borrower pays on education loans.

Also, most student loan companies, EdFed included, offer what are known as “borrower benefits” to their consolidation clients who take advantage of direct-withdrawal options or make a set number of payments on time. Usually, borrowers can reduce their interest rate by 1.25 percent, which, as we’ve shown, can add up to a lot especially when the loan principal is a six-digit figure.

Article Title : Grads Take an Interest in Student Loans

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Education is one of the most basic right of any human, but with the increase in prices and the costs involved in education this has made these rights turn into a privilege which very few can enjoy. Any normal person today in the whole of United States has to take an education loan at one point of time to pay for their education fees.

While you are attending school and after you graduate, be sure to establish and protect your good credit rating. Make all loan and other payments on time; use cash instead of credit cards; and monitor your spending habits.