Excerpt from: Higher Education Perspectives
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| April 07, 2009 | | While APR has traditionally been emphasized as an easy way to compare loans, does it truly help students understand their options enough to make an informed decision? | The Federal Reserve has recently posted revised disclosure requirements for private student loans and is requesting commentary and suggestions for changes to the disclosure requirements. One area the Fed is looking into is the display of the Annual Percentage rate (APR) and interest rate. It has been determined that prominently displaying both the interest rate and the APR causes confusion among consumers, as they are often unaware of the difference between the two rates and believe it is an error to display two different rates. This begs the question of which rate is more descriptive and helpful to consumers, and thus should be more prominently displayed.
APR is a good tool for comparison between loans with similar terms, repayment options, and grace periods. When these variables are held constant, APR accurately compares the cost of the loans based on the interest rates and fees. Unfortunately, these variables are not held constant for students shopping for loans. The variety in repayment plans offered to students largely invalidates APR’s ability to accurately compare various loans.
The various repayment types offered for student loans are the biggest pitfall for using APR as a comparison tool. In some cases, students are allowed to defer principal and interest for up to 8 years, which extends their loan term while leaving the repayment period constant. This strategy can drop the APR below the interest rate, but simultaneously increases the loan’s total cost by leaps and bounds. An immediate repayment loan would have significantly higher APR, and yet much lower total cost.
Full deferment isn’t the only repayment option that is misleading. Making interest-only payments while in school will reduce the APR shown to students while increasing the total cost. The table below shows calculations for APR and total cost for the various repayment types (scenario is set for a freshman in a four-year institution taking a $10,000 loan). The trend clearly shows the how misleading APR can be – while APR decreases, the total cost rises.
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Repayment Type
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Interest Rate
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APR
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Total Cost
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Immediate Repay
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8.05%
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8.75%
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$21,209
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Interest Only
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8.05%
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8.64%
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$24,740
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Full Deferment
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8.05%
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8.04%
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$28,893
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Based on these examples of total cost rising and APR falling due to some loan attributes, it is hard to argue that APR is a qualified comparison tool to be used for shopping for a private student loans.
While there would be substantial benefits to ending the use of APR for the comparison of private student loans, there are also some side effects to be considered. In my next entry, I will examine the effects of not prominently displaying APR and how it would change the shopping experience for students who need a private loan.
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