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Student loan interest rates are at a 20-year high and continuing to rise. Combine these higher interest rates with the high cost of college, and it can be daunting for students and their families.
What's going on? Why is there this apparent contradiction between the two federal guidelines regarding student loan interest rates?
We explain why student loan interest rates are rising, what you can expect as a current borrower, and what future borrowers need to know.
Interest rates are rising
Interest rates on new government student loans for bachelor students have almost tripled since 2020. They have increased in recent years:
Although interest rates are rising, they are currently only slightly above the historical average. The 2020-2021 rate was a record low, making subsequent rates appear higher.
However, it is likely that interest rates will continue to rise.
How interest rates for student loans are determined
Federal student loan interest rates change on July 1 and apply to all new loans through June 30 of the following year. Interest rates are fixed and do not change for the life of the loan.
The new interest rates will be set using a formula based on the high yield from the last 10-year Treasury bond auction in May, plus a margin.
For example, the maximum yield at the May 8, 2024 auction was 4.483%. Adding the 2.05% margin gives an interest rate of 4.99% for Federal Direct Stafford Loans for students. For Federal Direct Stafford Loans for graduates, the margin is 3.6%, and for Federal Direct Grad PLUS and Parent PLUS loans, the margin is 4.6%.
The recent interest rate increases on federal education loans are not intentional, but the result of an interest rate formula that Congress passed in the Higher Education Act of 1965. The current formula has been in effect since 2013.
Interest rates are influenced by the inflation rate
Inflation is caused by a mismatch between the supply and demand for goods and services. When this happens, the Federal Reserve tries to control the inflation rate by raising interest rates. In theory, this will reduce demand for goods and services because it will become more expensive to borrow money to pay for things. It also causes stock prices to fall, making investors feel less wealthy and therefore less inclined to spend money.
The Federal Reserve Board aims for an inflation rate of less than 2%.
The Consumer Price Index (CPI-U) rose by over 2% in March 2021 and has remained above that level since then. It is currently still above 3.5%.
When the Federal Reserve raises the federal funds rate, it affects the interest rates on 10-year Treasury notes, which in turn affects the interest rate on federal student loans.
The Federal Reserve
The Federal Reserve has kept its key interest rate at 5.25-5.50% this year, with a slight reduction in interest rates expected in the fall.
The Federal Reserve has stuck to its course because higher interest rates have so far proven ineffective in cooling inflation. Raising interest rates will not solve the supply chain problems or poor fiscal management that are causing at least some of the current high inflation rates.
Fortunately, Federal Direct Stafford Loans for undergraduates are capped at 8.25%, so interest rates can't go any higher. Federal Direct Stafford Loans for graduates are capped at 9.5%, and Federal Direct PLUS Loans are capped at 10.5%.
The effects of interest rate increases
Interest rate increases do not have as big an impact as borrowers assume.
Let's take the example of a $10,000 loan with a 10-year repayment period.
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What is the interest percentage (per payment)? |
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Even with a sharp rise in interest rates The majority of each payment will continue to be used to repay the principal or original loan amount.not the interest.
Of course, monthly loan payments involve more interest and less principal at the beginning of the term and then gradually increase, making the total amount you borrow more expensive. Just over half of each payment goes toward interest in the first and second years of a 10-year repayment period.
If you decide to take out a personal loan
There are ways to mitigate the impact of rising interest rates if you plan to take out a student loan for the next academic year.
Although variable interest rates may initially be lower than fixed interest rates, variable interest rates can only go up. (Note: interest rates on federal student loans are fixed.) However, private student loans often come with a choice between fixed and variable interest rates.
When taking out a private student loan, the fixed interest rate is likely to be lower for shorter repayment periods than for longer repayment periods.
You might also consider turning to nonprofit lenders for private loans. These lenders have lower financing costs because they can use tax-free municipal bonds. You can find the list of nonprofit lenders here.
Get your credit score
Remember to check your credit reports for free at annualcreditreport.com at least 30 days before applying for a private student loan. Get any errors corrected by disputing them. The lender has 30 days to confirm the accuracy or remove the incorrect information. Correcting inaccurate information will improve your credit score, which could result in a lower interest rate.
If your credit score isn't the best, apply for a private student loan with a creditworthy cosigner. Lenders calculate interest rates based on the borrower's credit score and the cosigner's, whichever is higher.
Choose a shorter repayment period
A shorter repayment period will reduce the total interest paid over the life of the loan, but will increase the monthly payment. Choosing a longer repayment period will reduce the monthly loan payments, but will increase the total payments over the life of the loan.
Refinance your student loans if you had a higher interest rate several years ago. (Be cautious about refinancing government loans into private loans, as government student loans offer better benefits, including longer deferments and payment deferrals, income-based repayment terms, payment pause and interest waivers, and options for debt forgiveness and discharge.)
The table below compares the best student loan lenders that also offer refinancing.
Sign up for autopay, which automatically transfers your monthly student loan payment from your bank account to the lender. Most lenders offer a 0.25% or 0.50% interest rate reduction as an incentive.
Don't forget to claim the student loan interest deduction on your federal income tax return, which is an above-limit exemption of up to $2,500 in interest paid on federal and private student loans.
Final thoughts
Remember: If you already have a federal student loan, you will not be affected by the upcoming increases – they only apply to new loans for the coming academic year.
However, it can still be worrying to see interest rates rise at such an expensive time. However, if you are taking out private loans, make sure you know how much you will have to pay back and whether it is worth foregoing the benefits of government loans. For example, a private lender may not be as flexible in helping you in the future if you struggle to repay the loan.
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