How Rising Interest Rates Affect Your Student Loans
How Student Loan Rates Are Determined
The government sets interest rates for new federal student loans each year in May based on the 10-year Treasury note. Federal student loan rates take effect July 1 for loans taken out for the upcoming academic year. The rates are always fixed, which means they stay the same over the life of the loan.
Lenders and banks set the rates for private student loans, and you can have the choice between fixed or variable rates. Lenders may use an index (e.g., LIBOR, Prime) to set their rates. Like federal loans, fixed rates stay the same for the life of the loan, but variable rates can change. Variable rates generally start off lower than fixed rate loans and can go up or down multiple times over the life of the loan as the index changes, which will affect your monthly payment.
Borrowers Need to Be Ready for Rising Rates
If you're taking out federal student loans for the 2018-19 school year, the rates for new Direct Unsubsidized, Subsidized and PLUS loans increased for a second consecutive year since 2017. Keep in mind that the rate changes are only for new loans. Rates for federal loans you have previously taken out won't change because they are fixed when you take out the loan for the life of the loan.
Changes to the fixed and variable interest rates offered for private student loans are also always possible since lenders set their rates based on a number of factors, including Federal Reserve policy. This can make those changes harder to predict, but we are in what economists call "a rising-rate environment." "The Federal Reserve has been gradually raising its short-term interest rate for a little more than two years now," says Alexander Lowry, executive director of the master of science in financial analysis program and professor in the practice of finance at Gordon College in Wenham, Massachusetts. At its policy meeting in March 2018, the Federal Reserve raised the short-term rate for the sixth time since the end of 2015. The forecast called for at least three additional rate hikes through the end of 2018.
The Federal Reserve doesn't follow a set schedule for issuing rate hikes. Instead, they make changes based on market conditions to maintain economic growth, and there's no rule for how much the Federal Reserve can increase rates each time.
What Options Do Borrowers Have?
To better manage possible rate changes, it's important that students "focus on getting to know their loans," Lowry says. That means understanding your federal or private student loans options, the type of repayment plans available and what your consolidation or refinancing options are before taking out loans.
You may not get to choose the rate type for federal student loans, but you do have options to lower your payments if you aren't earning a lot. Federal loans have more repayment plans — including income-driven repayment options - than private loans. You may also be able to consolidate your federal student loans into one loan, which will not lower your rate, but it will change it to one that is a weighted average of the loans being combined.
With private student loans, if you know you are going to pay off your loan quickly, or plan to refinance at some point, then choosing a lower starting variable rate may be a good choice. If you aren't sure how quickly you can pay off your loan or if you aren't sure you can refinance, then getting a fixed rate offers more stability long term.
Refinancing private student loans is similar to consolidation, but you are taking out a new loan to pay off your existing loans. Like federal consolidation, you can lower your payments, but with refinancing you may also get a lower rate. Lowering your rate or switching from a variable rate to a fixed rate may help borrowers manage their monthly payments.
It's possible to refinance federal and private student loans together, but think this through before you do it. When federal loans are refinanced using a private loan you can lose some key benefits like income-driven repayment options.
Keep in mind that if you increase the time it takes to repay your loans either through your repayment plan, consolidating or refinancing, you can end up paying more in interest over the life of the loan, increasing the overall cost of your loan.
Planning Can Ease the Impact of Rising Rates
Although it can be tough to do — especially when you're in the throes of college papers, exams and extracurriculars — students should think ahead about what a rate increase might mean for their budgets once it's time to repay their loans.
If you're planning to borrow student loans, take time to calculate exactly how much money you really need. Only borrowing what's truly necessary to pay for tuition, fees, books and living expenses can help you avoid extra student loan debt should rates rise. Making small or interest-only payments while you're in school can also help save you money over the life of the loan.