Some of you know me from my real estate and mortgage blog. I was poised a question in one of the online forums. So, I decided that it would be a worthwhile Blog entry.
The entire lending industry appears to be the verge of a total re-vamp. But here's some basic guidelines that are basic standards for the lending industry.
Congress recognized a need for standardization in the consumer lending arena a number of years ago. So it enacted the "Truth in Lending Act," and charged the Board of Governors of the Federal Reserve System with the task of coming up with a set of rules called “Regulation Z” that lenders must follow when advertising consumer credit – which includes private student loans.
With 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's some basics to enable you to become an effective comparison shopper for student loans.
Origination Fee. Most lenders charge an Origination Fee or “O Fee” on their private, credit based student loans. This fee, which usually varies depending on the borrower’s credit history, income, and other credit-base 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.” Note: In mortgage lending, origination fees can be less if you are workin with a portfolio lender or an entity that services it's own paper.
Index. The index is a published interest rate which is the base rate specified in the loan documents a borrower signs to which a rate known as the “margin” or “spread” that is specific to your situation is added for a determination of a loan’s overall interest rate. Indices are widely used in financial circles and are never set by us. Typically, the index used is the Prime Rate or LIBOR.
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. We use the Prime Rate as our index and update our 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 consider your 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 based upon review of an applicant’s credit history (or the credit history of their co-applicant), their income and other credit based criteria unique to each lender.
Repayment Fee. A fee that is often charged on loans with total deferment in which there is capitalization of interest at the start of the principal repayment period.
Now, one would think that by comparing the “overall interest rate” of two loans, one could determine which loan was less expensive.
But one would be wrong.
The “overall interest rate” doesn’t reflect a lot of other items you’re paying, such as the O Fee and any Repayment Fee. Which brings us to the concept of APR – the “great equalizer” when it comes to shopping for student loans.
APR. This stands for “Annual Percentage Rate.” And 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 its APR. So ANY student loan you could POSSIBLY want is going to have this key information disclosed "clearly and conspicuously" in compliance with Reg Z.
A word of warning, when you are comparing student loans, make sure that 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 only way to make a fully informed financial decision and the right financial decision for you.
Truth in Lending Disclosure. This document – sometimes referred to as the “TIL” – is sent to the borrower(s) prior to or when the loan is consummated which is when the first check is disbursed for the loan. It contains four (4) figures about the loan which contain 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.
Onward and Upward.
You now have the tools and knowledge to make an informed decision about the student loans that you need.
There’s no chance of you being taken in by offers of low “teaser rates” that shoot up after graduation. Secure in your understanding of key financial terms, you would no more confuse an Index with a Spread – or the LIBOR with the Prime Rate – than you would mistake a mouse for an elephant. Thanks to Reg Z, you know 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.