Ara Oghoorian CFA, CFP® is an investment advisor who founded ACap Asset Management, a fee-only financial advisory firm in Los Angeles who specializes in assisting physicians.  He writes a blog and submitted this as a guest post.  We have no financial relationship.

According to a March 2012 study by the Federal Reserve Bank of New York, the average outstanding student loan balance per borrower is $23,300; a quarter of borrowers owe more than $28,000, and 0.45 percent of borrowers owe more than $200,000. If you continued on to medical, business, or law school, you are probably in the latter debt category with a six-figure student loan balance wondering how to tackle that monkey on your back. Students have a variety of loan options to choose from when deciding how to fund college [and medical school] expenses, but it is critical to understand the details and requirements of the loan taken out to pay for higher education. This article will explain the difference between subsidized and unsubsidized student loans, describe the different types of student loans, and help you decide when to consolidate loans.

Subsidized versus Unsubsidized Loans

First, let’s compare subsidized and unsubsidized loans. Whenever you borrow money, you owe interest on the outstanding balance of your loan; when interest on a student loan begins to accrue depends on whether the loan is subsidized or unsubsidized. If you have a subsidized loan, the interest does not begin to accrue until after you have graduated and begin to repay the loan;  whereas if you have an unsubsidized loan, the interest begins to accrue the moment the loan funds are disbursed.

This important difference explains why some students graduate and notice that their student loan balance is much higher than they had anticipated. Assume you only borrowed $20,000 at 5 percent to fund the first year of your 4-year undergraduate degree; if that loan was subsidized, the loan balance would still be $20,000 when you graduate, and the interest will begin to accrue at 5 percent once your grace period ends and repayment begins. However, if your loan was unsubsidized, your loan would have accrued interest of $1,000 at the end of your first year of college. If you did not pay that $1,000, it would get added to your initial $20,000 balance (known as capitalized interest or negative amortization) and this process would continue until you began making payments on the loan. Below are the two loans compared side by side:

Loan Balance (Subsidized versus Unsubsidized)
Year-End

Subsidized

Unsubsidized
Freshman

$20,000

$20,000 x 1.05% = $21,000
Sophomore

$20,000

$21,000 x 1.05% = $22,050
Junior

$20,000

$22,050 x 1.05% = $23,152
Senior

$20,000

$23,152 x 1.05% = $24,310
Loan Balance Upon Graduation

$20,000

$24,310

 [A more relevant example for this blog’s readers might take a look at an unsubsidized $20K loan you take out as a first year medical student at 6.8%.  After 8 years (4 of med school and 4 of residency) of not making payments on this loan, it would stand at $33,853, or 69% more than the original loan.  Remember that not only are medical student loans at the higher 6.8% rate, but they are no longer subsidized starting this Fall.]

Types of Loans

Perkins Loans

Perkins loans are subsidized and are for those students with exceptional financial need and can be used for both undergraduate and graduate degrees. Perkins loans are fixed at 5%, have a repayment period of up to 10 years, and amount is limited based on your undergraduate or graduate status.

Direct Stafford Loans

Stafford loans are also for undergraduate, graduate, and professional students, but they can be either subsidized or unsubsidized. Direct Subsidized Loans are for students with financial need, and as long as you are in school at least part-time, within your grace period, or on deferment, you are not charged interest. Direct Unsubsidized Loans do not require demonstration of financial need and are available to all students.

PLUS Loans for Graduate and Professional Degree Students:


PLUS loans are for graduate and professional degree students and have a fixed interest rate of 7.9 percent. You must have a good credit history to be granted a PLUS loan, and you must have exhausted your eligibility for Direct Subsidized and Unsubsidized Stafford loans. PLUS Loans have a 4 percent fee charged on the loan amount, which is deducted from the loan proceeds. There are repayment plans that will allow you to amortize your loan between 10–25 years.

Loan Consolidation

Do you have several types of loans from various lenders from your undergraduate and graduate years? Are you paying multiple loans and at different interest rates? The Department of Education’s Direct Consolidation Loan may be just what you have been looking for. The Direct Consolidation Loan pays off all of your loans and gives you one loan with a single payment and a fixed interest rate. The interest rate is determined by taking the weighted average interest rate of all your loans capped at 8.25 percent. Additionally, if some of your loans are variable (can increase if interest rates rise), the Direct Consolidation loan will convert those to a fixed rate as well. Unfortunately, not all loans qualify for the Direct Consolidation Loan. For example, private loans and loans not guaranteed by the federal government are not eligible. You can learn more at this government loan consolidation site.  [Keep in mind that consolidating variable rate loans at this time is likely to actually increase the rate you are paying given our current low interest rate environment.]