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Financing college has always been a challenge, but this year could be the worst ever. Rounding out a miserably difficult financial aid season, interest rates on federal direct loans will rise for students and parents. a lot.
Let's explore why interest rates are rising, offer some strategies for getting loans at the lowest possible cost, and talk about personal loans as a possible alternative to the Direct PLUS loan.
Student Loan Basics
Each year, the Department of Education's Federal Student Loan Program loans more than 90% of all the money that undergraduate and graduate students and their parents borrow to finance their education. This article focuses primarily on loans for dependent students and their parents.
The direct loan program offers students the best loan conditions for studying. As explained below, this may not be the case for their parents.
To be eligible for a federal student or parent loan, students must submit a FAFSA® form.
- All students are eligible for a direct federal student loan, regardless of their or their parents' income or assets.
- Parents who do not have adverse credit are eligible for a Direct PLUS loan.
All other education loans are called personal loans (also called private credit loans) and are issued by lenders other than the federal government.
Private lenders include governments (through government agencies or special nonprofit organizations), colleges, banks, credit unions, and other financial services companies. Each lender has its own loan application, criteria for determining whether to lend to you (also known as your “credit score”), and loan options with interest rates based on your credit score.
Why are student loan interest rates rising?
All loans made under the Direct Lending Program are fixed-rate loans, meaning that the interest rate does not increase or decrease over the life of the loan.
The fixed interest rate for Direct Loans changes on July 1st each year and applies to all Direct Loans issued from July 1st to June 30th of the next year. For loans issued between July 1, 2024 and June 30, 2025, the Student Direct Loan interest rate is 6.53%. The PLUS loan rate is 9.08%.
Related: Best student loan rates
Direct Loan interest rates are set using a formula that requires the U.S. Department of Education to add 2.05% for Direct Student Loans and 4.60% for Direct Loan PLUS to the yield on the 10-year Treasury note auctioned each May. On May 8, 2024, the 10-year Treasury note was auctioned for 4.48%, resulting in interest rates of 6.53% and 9.08% for Direct and PLUS loans, respectively.
The result of this year's 10-year Treasury auction was 1.03% higher than last year's auction, meaning higher interest rates for students and parents.
Direct credit limits
If the FAFSA process determines that a student has “financial need,” they will be offered direct subsidized loans. Interest on subsidized loans only begins to accrue at the start of the repayment period, usually six months after leaving school.
Students with financial need are eligible for both direct subsidized loans and direct unsubsidized loans. Students who have not been assessed as having financial need are also eligible for direct, unsubsidized loans, which require borrowers to either pay interest while in school or add accrued interest to the original amount borrowed.
The amount students can borrow depends on their academic year:
- Students in the 1st year of study: up to $5,500, with no more than $3,500 subsidized
- Students in the 2nd year of study: up to $6,500, with no more than $4,500 subsidized
- 3rd year and beyond: up to $7,500, with no more than $5,500 subsidized
Dependent students are allowed to borrow a maximum of $31,000, of which a maximum of $23,000 is in subsidized loans.
Parents can borrow Direct PLUS loans up to the amount of the college-certified cost of attendance.
Strategies for Minimizing Student Borrowing
In addition to appealing to the college for more grants and scholarships and/or having a student work while in school to reduce student loans, families should:
Borrow as little as possible
The first and most important question people ask: How much should we borrow? The answer is always the same: as little as possible. But that's not helpful, so here's a rule of thumb that most experts accept: Students should not borrow more than their expected starting salary in the first year.
Although a difficult and emotional decision, if a student needs to borrow significantly more money than their expected starting salary, finding a less expensive school or taking a gap year to build up savings may be the smart choice.
Pay interest while the student is in school
With unsubsidized loans, paying interest in school means the student graduates with the exact amount they originally borrowed. When no interest is paid in school, it is added to the original amount borrowed (this is called capitalization). When repayment begins, they then pay interest on the new, higher balance.
Find scholarships
Look for scholarships to reduce the loan amount. Use this free scholarship search with over 6,000 scholarships to find money that doesn't have to be paid back.
Use a tuition payment plan
Payment plans generally charge a one-time fee to pay a portion of the tuition bill. For example, a family might realize that they can use money from their job to pay part of their college tuition each month.
Let's say the family can afford to pay $100 per month and chooses a payment plan that allows them to pay the $100 per month for 10 months. The company pays the college $1,000 and the family makes the $100 monthly payments to the tuition payment company. This can be a practical way to use current income to reduce student loans.
Compare personal and PLUS loans
Check whether a personal loan might be cheaper and more attractive than the Direct PLUS loan.
Understand the full costs. In addition to an interest rate of 9.03%, PLUS loans come with an upfront origination fee of 4.23%. Unlike private lenders, which are required to disclose the annual percentage rate (APR) on a loan, the Department of Education is not required to disclose the APR, which is higher than the interest rate on PLUS loans due to the upfront fee. Generally, private lenders do not charge upfront fees.
Know who the borrower is. PLUS loans are awarded to parents – they cannot be transferred to the student. Private lenders allow a student to apply with a co-signer (usually a parent) and often offer a “co-signer release,” which allows the parent to exit the loan if certain conditions are met. Cosigner releases are not available for Direct PLUS loans.
Note that the word “in general” is used throughout. You should check the lender's website for the details of each private student loan offer.
Considerations for private student loans
If you're thinking about private student loans, here are some additional considerations.
The family picture. When parents compare the PLUS benefits with the additional costs and inability to get loan exemption, they should keep the bigger picture in mind. Some helpful questions to consider:
- Do we have other children who may need help?
- Is this a one-time borrowing or do we have to borrow at least that much every year until we graduate?
- Will paying our children's college fees jeopardize OUR financial future or our retirement?
Direct PLUS loan alternatives. If you choose a parent loan, consider the following factors when evaluating a personal loan:
- Conditions: Generally, private lenders offer loans with no origination fee, a 0.25% interest rate discount with automatic payment, various repayment programs, fixed or variable interest rates based on your credit score, and co-signer approvals.
- Interest charges: Generally, private lenders use a FICO or other credit score as a key to their underwriting criteria. They either refuse to grant a loan or offer it at an interest rate based on the applicant's creditworthiness. Weaker credits are offered loans with higher interest rates than stronger credits.
Government lenders often offer loans with lower interest rates. Generally, government lenders fund their programs with tax-exempt bonds. Their lower borrowing costs translate into lower interest rates for their customers. Many of these institutions are members of the Education Finance Council. You can find your private student loan programs here.
This year, due to technical market conditions, federal lenders are likely to offer loans with interest rates well below the 9.03% PLUS loan rate. Your current tax-free borrowing cost is well below the 10-year Treasury rate of 4.48%. Many will be able to offer loans in the 6% to 7% range to their top tier applicants (FICO scores above 740) and many middle tier applicants (700-739). Borrowers with lower credit scores (670 – 699) are also likely to be offered loans under 9.08%.
Other lenders, such as banks, credit unions and financial companies, fund their loan programs in the taxable markets. Some are also likely to offer loans to many borrowers at interest rates lower than the PLUS rate of 9.08%.
Buyer beware: variable rate loans
Private lenders offer fixed and variable interest rate loans. Be careful with variable rate loans. The initial rate will rise and fall over time. A loan with a variable interest rate that may be very cheap today can become a burden if interest rates rise. Make sure you know how often the interest rate adjusts (usually monthly) and the maximum interest rate the lender can charge (often the government usury rate, which can be very high). The phrase “know before you owe” is especially true for variable rate loans.
When carefully considered, student loans represent an important part of a family's plan to finance their college education. Smart borrowers are sure to have a good understanding of the terms and conditions before the electronic signature is obtained. My College Corner hopes you keep one of our favorite phrases in mind: Student loans should be the last resort and not the first option to finance your studies.
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