APR
Annual Percentage Rate, or APR, shows the cost of a loan on an annual basis including up front fees. Imagine if shopping for a shirt and finding one that had many price tags: one for the sleeves, one for the buttons and one for each pocket. You’d have to total them all up to get the price. An APR on a loan attempts to total up the price, which includes loan fees and other costs associated with getting a loan.

Fixed and Variable Rates
Interest rates come in two varieties: fixed and variable. Fixed rates don’t change throughout the life of the loan.

With variable rates, the rate can change throughout the life of the loan. Most alternative loans have variable rates.

Index
All variable rates have an index, or a base rate. An index is the price a lender pays for money, and lenders have to mark it up to cover their expenses. For example, a clothing store might buy a shirt from the manufacturer for $15 but mark it up to $50 to cover their expenses such as rent, salaries, etc. Lenders do the same thing.

Floor and Cap
Most variable rates also come with a floor and a cap. The floor is rarely mentioned, but it’s the lowest a rate will be allowed to go. Caps are more frequently used -- a limit to how high a lender will raise a rate on a variable-rate loan.

Adjustment Period
Most variable rates have an adjustment period for how often a rate will change. The purpose of the adjustment period is to make budgeting/planning easier because the borrower can anticipate payment changes.

Index Types
Lenders get money to lend from difference indexes. Think of the index rate as the wholesale price and the index name as the place where the lender obtained the money. Think of the rate the borrower pays as the retail price.

Prime Rate
The prime rate goes to the most credit-worthy consumer and is usually the lowest interest rate.

T-bills
Another source of money for banks is the government or Treasury bill index. Treasury bills finance the U.S. deficit. When the federal government needs more money it borrows it by selling IOUs or Treasury bills. The government provides this money to banks so that they can lend it out.

LIBOR
The London Interbank Offered Rate (LIBOR) is a rate major international banks charge each other for loans, usually to cover short-term cash flows.

Commercial Paper
Another rate is the commercial paper rate. This one isn’t used as much as the prime, LIBOR or T-bill. Similar to the LIBOR, the commercial paper rate is for loans between corporations.

Other Loan Terms
Two terms often heard with alternative loans are guarantee fee and origination fee. Both are paid up front and are expressed as a percentage of the loan amount. These fees add to the cost of borrowing money. In general, most up-front fees are included in the APR.

Most Stafford loans no longer have guarantee fees, and origination fees on Stafford loans are not income to the lender; they’re passed along to USED.

However, alternative loan origination fees are income to the lender (because alternative loans are not guaranteed) and are included in the APR.

One of the least friendly words in loan jargon is amortization. An amortization schedule is simply a payoff schedule, which means reduction of debt with regular payments of interest (the cost of the loan) and principal (the actual amount borrowed).

An even less friendly term is negative amortization. Essentially, it means increasing the loan balance because a monthly payment does not cover principal and/or interest. As a result, the loan balance grows. This is especially possible in a rising rate environment.

Associated with negative amortization is capitalization, which means adding interest to the loan balance. Think of it like this: Capital is money borrowed. Interest is paid on capital. When interest becomes part of the capital it is “capitalized.”

For more information, contact Michael Amaloo, EdFund Client Relations Manager at: 512.405.3800, Fax: 512.405.3801, mamaloo@edfund.org