Definition and Example of a Subsidized Loan
When a lender applies a subsidy to the interest portion of a loan on behalf of the borrower, it's defined as a subsidized loan. The lender generally pays the interest charges on the loan during certain periods. The subsidy has the effect of reducing the borrower's periodic loan payment in periods during which it is applied, thereby making loan repayment more manageable, lowering the total cost of the loan, and saving the borrower money.
Governmental agencies at the federal, state, and local levels, as well as non-profits, may offer subsidized loans, but federal agencies most commonly extend subsidized loans. When they do, they tend to be reserved for low-income borrowers, meaning that borrowers often have to demonstrate financial need to obtain them. One common example of subsidized loans is a federal student loan through the Department of Education.
Not all federal student loans are subsidized. A financial aid package may include a combination of both subsidized and unsubsidized loans.
How Does a Subsidized Loan Work?
The following example describes the function of these loans:
- Joe plans to enroll at a four-year college. After calculating the cost of attendance and accounting for a scholarship from the school, he still needs $10,000 to cover educational costs over four years.
- He takes out an annual Direct Subsidized Loan of $2,500 at an APR of 2.75% that accrues daily, or $10,000 for all four years, repayable over a 10-year term.
- Joe maintains full-time enrollment throughout his college years. The lender, the U.S. Department of Education, pays the interest that accrues on his Direct Subsidized Loan for the full four years plus up to six months after graduation.
- Joe graduates. He has $10,000 in debt at the start of repayment, thanks to interest-free borrowing for four years and six months, and his monthly payment over the 10-year period is $95.
The aggregate limit that dependent and independent students can take out in Direct Subsidized Loans over the course of their undergraduate education is $23,000, and subject to adjustments annually.
Types of Subsidized Loans
There are two major subsidized loan offerings:
- Federal student loans: The U.S. Department of Education pays for the interest on Direct Subsidized Loans during certain periods—while you're enrolled on an at least half-time basis, for the first six months after you leave school, or during a deferment (a temporary postponement of payments). However, only undergraduate students who can demonstrate financial need are eligible for Direct Subsidized Loans.
- Federal home loans: The U.S. Department of Agriculture (USDA) and other federal agencies offer loan programs through which low- or moderate-income borrowers can obtain subsidized home loans. For example, a USDA Single Family Housing Direct Loan comes with a payment-assistance subsidy that reduces a borrower's monthly payments and the effective interest rate on the loan.
Some subsidized home loans have a "subsidy recapture" feature that requires borrowers to repay the subsidy when they dispose of the property.
Unlike subsidized loans wherein the lender pays the interest that accrues on the loan during certain periods, unsubsidized loans hold the borrower responsible for paying interest on the loan during all periods.
Subsidized vs. Unsubsidized Loans
Direct Unsubsidized Loans offered by the U.S. Department of Education are a common example. You'll have to pay any interest that accrues while you're in school and during grace periods or deferments, resulting in higher total loan costs and monthly payments than you would rack up with a subsidized loan, as the earlier example of the two students shows. The cost differential increases if the recipient of an unsubsidized loan opts not to pay interest during school, which triggers capitalization. A student who takes out a subsidized loan won't pay interest that accrues during these periods or face capitalization.
|Subsidized Loans||Unsubsidized Loans|
|Lenders pay interest charges.||Borrowers are responsible for all interest charges.|
|Borrowers reduce their overall debt and monthly payments.||Borrowers incur more debt and face higher monthly payments.|
|Borrowers have to demonstrate financial need.||Loans are non-need-based.|
Going back to the earlier example, let's say that Jenny took out a Direct Unsubsidized Loan with the same terms as Joe's Direct Subsidized loan. As such, she's liable for any interest that accrues on her loan for four years. Moreover, she opts not to pay interest while in school, so any unpaid interest is capitalized or added to the loan principal. Jenny already has $10,821 debt at the start of repayment after accounting for interest accrual and capitalization. Over a 10-year repayment period, Jenny pays a higher monthly payment of $103.
That said, you don't have to demonstrate a financial need to be eligible for a Direct Unsubsidized Loan as you do in the case of a Direct Subsidized Loan. Depending on your financial situation, you may find it easier to obtain a subsidized loan.
How to Get a Subsidized Loan
To obtain a subsidized federal educational loan, fill out a Free Application for Federal Student Aid (FAFSA) form to determine what loan types and amounts you're eligible to receive. For federal home loans, go through the website of the federal agency overseeing the home loan program to determine eligibility requirements and request a loan.
Schools will generally send you information on how to accept a federal student loan at your chosen amount. You'll likely have to fill out a promissory note that outlines the terms of the loan and repayment, and you may need to undergo entrance counseling to ensure that you understand your obligations when you take out the loan.
When the loan is ready for disbursement, the school will first take out the necessary amounts for your tuition, fees, and room and board. If there's money left over, it will be returned to you or your educational needs, such as buying books or covering other expenses.
- A subsidized loan is one that a lender pays the interest charges on during certain periods.
- Federal student and home loans are the two main types of subsidized loans.
- Subsidized loans are usually targeted at borrowers with financial need.
- Eligible borrowers benefit from lower monthly payments and overall loan costs, but those who can't demonstrate may find it easier to obtain unsubsidized loans.