How Does a Subsidized Loan Work?

A loan subsidy pays for loan interest

When a loan is said to be subsidized it means that some, and most commonly all, of the interest due on the loan is paid for by a party other than the borrower. This means that the borrower gets to benefit from the capital without having to make up for the time value of holding the money. Subsidized loans are made to those with financial need who would be unable to pay or unduly burdened to make interest payments over a certain period of time, often with the expectation that interest will be paid at a future date.

Who can subsidize loans?

Any loan issuer can subsidize a loan if it wishes to incur the cost of paying interest for some reason. Some common loan subsidizers are the federal government, charities and religious institutions. The duration of a subsidy is usually set out in the terms of the loan being made--the purpose of the subsidy is to allow a time for the borrower to improve his financial situation, after which he will begin to take over the interest payments.

Stafford loans are a commonly subsidied loan

The most common type of subsidized loans are federally issued Stafford student loans. Loan subsidies are logical when it comes to education: students have little ability to pay for loans, they often need to borrow very large amounts of money and their earning potential is expected to increase greatly after a short period of study. In this way the federal government can make some money on interest in the long term, and students can attend a university or college that they would not otherwise be able to afford had they been forced to make interest payments while they were in school.

Another advantage to Stafford loans is that payments can be further deferred if one enrolls in a graduate program, so the loans do not offer a disincentive to seek higher education.