Student loans are a major burden for current and former grads, with many college students even admitting they'd consider spending time in jail if it meant freedom from repaying them. But some student loans are a bigger burden than others.
Federal Direct Loans are widely viewed as the best and most affordable type of student debt but there are two types of direct loans: Subsidized and unsubsidized. While both have benefits over private loans, a federal direct unsubsidized loan has hidden costs students should know about so they can plan for them – or avoid them.
What is a Federal Direct Unsubsidized Loan?
Both subsidized and unsubsidized direct loans are low-interest fixed-rate loans made by the Department of Education. Undergrads become eligible for them after completing their Free Application for Federal Student Aid (FAFSA) but only subsidized loans require students to show financial need. And grad students can only qualify for unsubsidized loans.
You don't need good credit to qualify for these Direct Loans, but there are annual and aggregate limits on the total you can borrow. Both subsidized and unsubsidized loans also offer important borrower protections including access to income-based repayment plans, loan forgiveness options, and the chance to pause payments using deferment or forbearance.
But while the government subsidizes interest on Direct Subsidized Loans while borrowers are in school or loans are deferred, interest on federal direct unsubsidized loans isn't covered by the government and borrowers are always responsible for paying it.
What's the biggest difference between subsidized and unsubsidized student loans?
Students can defer payments on all Direct Loans while in school at least half time, for six months after graduation, and if they meet qualifying requirements after graduating. Unfortunately, interest accrues on unsubsidized loans from day one – and unpaid interest is added onto your loan balance when you enter repayment. That addition of unpaid interest is called "capitalization."
Capitalization makes loans very expensive because you end up paying interest on interest -- not just on the amount borrowed. A freshman with $5,500 in unsubsidized loans who does not make payments until six months after graduation could see interest accrue for 54 months. At an interest rate of 4.53 percent, his loan balance could balloon to $6,621 after $1,121 of unpaid interest is added on.
Going forward, interest will be calculated based on this higher balance and payments will be higher because of it. Depending on what your degree is worth and how much money you make after graduation, capitalization of interest on unsubsidized loans may mean these loans become difficult to repay.
How can you avoid a ballooning loan balance?
Student borrowers should always max out Direct Subsidized Loans before taking on any unsubsidized debt – although direct unsubsidized loans remain a better deal than private loans in most cases.
And those who do take out unsubsidized loans should consider making interest payments while in school to avoid capitalization and ensure the loan they start repaying after graduation doesn't have a balance that's thousands more than they borrowed.