The cost of a college education is continuously on the rise. Many students need to take out loans to afford their higher education, but the loan process can be confusing to students who have never had to take a loan. Federal student loans are the most common loans utilized by students because the standards of approval are not as restrictive as private loans. The two most common federal student loans fall into two categories: direct subsidized and direct unsubsidized. Although over 30 million students apply for both types of loans annually according to the U.S. Department of Education, they often do not understand the difference between the two.
Why is it important to know the difference?
The first lesson that a college student should learn is the difference between a subsidized and unsubsidized loan. This difference is important to understand because it directly affects you during college when interest is accruing on these loans and after college when these loans become due. This information will help you strategize:
• how much you should borrow
• how loan interest is calculated
• if you should make payments while in school
• if you should defer payments until after graduation
• where the amount of your repayment is applied
Direct Subsidized Loan
Generally referred to simply as subsidized loan, this type of loan is the most ideal to help the student both afford college and not worry about excessive interest accrual. As long as you are enrolled in college at least half-time, the government will pay the interest on your loans. That means that the amount you borrow as a freshmen is the balance that you will be expected to repay upon graduation. The responsibility of paying the interest on the loan after graduation becomes yours, but the government has kept the amount of the principal from rising while you were in school. If you request a deferral of your student loan after graduation the government will also pay the interest.
Pros and Cons of a Direct Subsidized Loan
| Pros | Cons |
|---|---|
| U.S. government pays the interest while you are in school | Not available for graduate students |
| U.S. government pays the interest while your loan is in deferment/forbearance | Based on financial need |
| No payments due for six months after graduation | Lower annual loan limits |
Direct Unsubsidized Loans
Unsubsidized loans are general loans that do not require the student to show a financial need before being approved. For this reason, the U.S. government does not make payments on the interest accrued on unsubsidized loans while the student is in school. The student is responsible for interest payments from the moment the loan is approved. The student can apply to defer the interest payments until graduation, but then those interest payments are added to the principal amount of the loan.
Pros and Cons of a Direct Unsubsidized Loan
| Pros | Cons |
|---|---|
| Undergraduate and graduate students can apply | All interest paid by student |
| Not based on financial need | |
| Annual loan limits are higher |
Subsidized vs. Unsubsidized: Understanding the Similarities
There are similarities between the two types of loans. Both have interest rates set by the U.S. government, and the interest rates remain the same based on the year the loan was distributed. Students can take out both types of loans regardless of their credit history since no credit check is needed for these types of loans.
Subsidized vs. Unsubsidized: Understanding the Difference
| Subsidized | Unsubsidized | |
|---|---|---|
| Interest | Paid by government while you are in school at least ½ time | You pay the interest while you are in school* |
| Financial Need | Must prove financial need | No proof required |
| Degree Program | Undergraduate only | All degree programs |
* You can pay the interest on an unsubsidized student loan while you are in school or request deferral of interest payments until after graduation. If you defer the payments until after graduation, the interest amount is added to the principal, increasing the total balance of the loan amount that collects interest and is due after graduation.
Amount, Fees, and Interest Rates
The maximum amount of money you can borrow in subsidized and unsubsidized student loans is determined by the U.S. government. For undergraduates, it is based on which year you are requesting the loan: freshmen, sophomore or beyond as well as whether you are a dependent student or independent student. The amount allowed for college juniors through graduate school is the same. These amounts are periodically reviewed by the U.S. Department of Education to ensure the maximum amounts allowed, the interest rates, and the fees associated with student loans are adequate to accommodate both students and lenders.
There are fees associate with processing student loan applications which are also set by the U.S. Department of Education. The fees are a percentage of the total loan amount, and that percentage can increase or decrease every year. Because the percentage changes, the fees are deducted out of each disbursement, which means the amount that is disbursed will be lower than the amount borrowed. However, you are responsible for paying back the entire amount borrowed before fees were deducted. So if you were approved for $100 disbursement and there was a $30 fee, you would only receive $70 but are responsible for paying back $100.
Interest on student loans begins to accrue immediately upon distribution of the loan money. It is calculated based on the balance of the loan remaining. If the interest is not paid regularly, it is added to the principal amount borrowed. This means interest is being calculated on the original loan amount plus the interest from last month. For ease of calculation, let’s say your original loan was $10,000 and your interest rate is 3% per month, your monthly interest payment for the first month is $300. If you pay that interest every month, then your monthly interest payment would always be $300 per month.
While you are in school, you can defer the interest payments due. What happens when you defer the interest payments is the interest accrues and is added to the principal amount of your loan. So after the first month of interest accrues, your loan balance becomes $10,300. This is the amount that is calculated again by 3%, and your monthly interest on the loan in the second month is now $309 and makes your principal balance $10,609. This balance is then multiplied by 3% so your interest in the third month will be $318.27, making your principal balance is $10,918.27. The amount of interest goes up every month because the interest is added to the principal amount of the loan every month that you do not pay the interest. This can dramatically increase the amount of your loan balance by the time you graduate.
Qualifications
One of the first standards you need to look at before applying for a federal loan is whether you are a dependent or independent student. If you still live with your parents or are under the age of majority for your state, you are considered a dependent student. Independent students have specific characteristics showing they are financially independent of their parents or guardians, such as being at least 24 years old or emancipated, married, have dependents, or are graduate students. Dependent students’ financial need is reviewed based on their parents’ or guardians’ income. While a parents’ or guardians’ income may be too high to qualify a student for a subsidized student loan, they would still qualify for an unsubsidized loan.
The other standard for qualification is related to your school program. You must be enrolled in an approved college program that participates in the Direct Loan Program at least half-time. Whether you qualify for subsidized student loans also depends on whether you are an undergraduate or graduate student, and what year of your undergraduate program you are in.
Repayment
You can often get student loan payments deferred until after graduation if you cannot make payments on at least the interest for your unsubsidized loans. After graduation, your loan servicer will send you information on how much you will need to pay per month in order to stay current with your loan repayment obligation. It is important that you make repaying your student loans a priority in your budget.
If you are able to make extra payments on the loans, it will certainly help you in repaying the loan faster. The best course of action is to make extra payments to the unsubsidized loans if you were not able to make payments while you were in school. Remember that the unsubsidized loans accrued interest while you were in school and you are now accruing interest on the whole balance, meaning you are accruing interest on your interest.
Understanding the difference between direct subsidized and direct unsubsidized student loans can help you decide how you want to finance your college expenses or at least how you want to manage your repayments for the loans while you are in school. This is valuable information for every student.