There’s an up-front fee you pay on a federal student loan, and many borrowers are unaware of it.
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Federal student loans have some valuable benefits, such as a low, fixed interest rate, the ability to enroll in income-driven repayment plans, and access to Public Service Loan Forgiveness, just to name a few. However, it’s important for borrowers to realize that there’s a little-known cost associated with federal student loans -- an origination fee that is deducted from each and every Direct Subsidized Loan, Direct Unsubsidized Loan, and Direct PLUS Loan.
Here’s a rundown of what an origination fee is, how much it will cost on your student loans, and how it affects your actual cost of borrowing money to fund your education.
What is an origination fee?
In simple terms, an origination fee is a charge assessed by a financial institution for facilitating a new loan. Origination fees are not only intended to compensate the lender, but are also used to cover lender costs, such as underwriting.
Origination fees are generally expressed as a percentage of the loan amount. For example, a 1% origination fee on a $20,000 loan would be $200. This fee may be deducted directly from the loan upon its disbursement, making the actual loan proceeds $19,800, or it may be paid directly by the borrower.
Standard origination fees vary by industry. Mortgages come with average origination fees of 1% or less of the loan amount, for example.
How much is the federal student loan origination fee?
Federal student loans have origination fees, which the Department of Education refers to as the “loan fee.” This is a charge that is a percentage of the loan amount that is deducted proportionally from your federal student loans at each disbursement.
This is an important concept to know, as it means that the actual dollar amount that is sent to your school will be somewhat less than the amount you’re agreeing to borrow and pay back.
For loans that are first disbursed from Oct. 1, 2018 through Sept. 30, 2019, the federal student loan fees are as follows:
Data source: Studentaid.ed.gov.
It’s also important to mention that these loan fees are subject to change every year. For the prior year, the two loan fees were 1.066% and 4.264%, respectively.
Until 2011, the loan fees were a flat 1% for Direct Subsidized and Unsubsidized Loans, and 4% for Direct PLUS Loans. However, the Budget Control Act of 2011 requires that origination fees be increased to help reduce the expense of the federal student loan program until certain spending legislation is enacted (it hasn’t happened yet). So each year -- usually in June -- the federal student loan origination fees for the upcoming one-year period, which always runs from Oct. 1-Sept. 30, are announced.
An example of a federal student loan origination fee
Here’s how this works. Let’s say that you’re a first-year college student and you agree to $5,500 in Direct Subsidized and Unsubsidized Loans for the upcoming 2019-2020 school year. Your loan is scheduled for its first disbursement in August 2019, so your loan fee will be based on the percentage in the table, or 1.062%.
This means that instead of $5,500, $5,441.59 will be disbursed to your school and $58.41 will be taken as an origination fee. It’s also important to point out that if your loan is disbursed over several payments -- such as half in the fall and half in the spring, the loan fee will be deducted proportionally from each disbursement, not all at once.
Why do federal student loans have origination fees at all?
Federal student loans are superior to those offered by the private sector in many ways. For example, the access to income-driven repayment plans, loan forgiveness programs, and flexible deferment options are all things you’re unlikely to find in the private sector. However, it’s not uncommon to find private student loans with no origination fees at all, which begs the question “why do federal loans have origination fees at all?”
In short, this is to cover the administrative and other expenses related to the federal student loan program. In other words, the fee helps to pay for the employees who process your loan’s paperwork, any office supplies used in the processing of your loan, and other such expenses.
How does the origination fee affect your APR?
Here’s the tricky part. Generally, when you take out a loan, there are two interest rate numbers you need to pay attention to. There’s the nominal interest rate, which is the amount of interest you’ll pay on an annualized basis as a percentage of your outstanding loan balance. For example, if you get a mortgage with a 5% interest rate, that’s what this number means.
There’s also the annual percentage rate, or APR, which takes not only your interest but the other costs of borrowing money into account, specifically loan origination charges. In other words, the APR tells you the true cost of borrowing money when you take fees into consideration. For example, a $200,000 30-year fixed-rate mortgage with a 5% interest rate that has a $3,000 origination fee would have an APR of 5.131%. This is the combination of the interest charges, plus the origination fee spread out over the term of the loan.
The point is that the true cost of a federal student loan is more than the nominal interest rate that is attached to it. However, there’s one unique characteristic of federal student loans that makes it impossible to calculate APR with accuracy -- there’s no specific repayment period.
In other words, when you take a mortgage or auto loan, you know how long you’ll be paying the loan back for. On the other hand, while the standard student loan repayment period is 10 years, many borrowers choose an extended repayment term. Or, borrowers may choose income-driven repayment, which can make the repayment term on a federal student loan anywhere from 10 to 25 years.
While the federal loan origination fee should definitely be taken into consideration when borrowing the money, it’s impossible to do an accurate APR calculation on a federal student loan.
For example, a $25,000 student loan at 5.05% interest with a 1.062% origination fee would have an APR of 5.282% if it were paid back over 10 years. If the repayment period was stretched to 20 years, the effective APR would drop to 5.178%.
The bottom line on federal student loan fees
To be perfectly clear, the origination fee you pay when obtaining a federal student loan can be well worth the cost. For example, the ability to qualify for income-driven repayment and certain loan forgiveness programs can more than offset the money deducted for fees. However, it’s important -- both now and as you go through your entire financial life -- to be aware of the true cost of borrowing money before you sign any loan documents.