Education is an incredibly valuable asset. However, it is not cheap when one seeks assistance through student loans. Federal and private student loans are among the most expensive forms of financing compared to other credit solutions such as a mortgage or car loans. Why are student loan interest rates so high?
Student loan interest rates are usually high because most of them are unsecured. Unlike secured loans that are attached to collateral, unsecured loans don’t come back with any form of tangible asset. Therefore, the lender is left to absorb all the risks should the borrower fail to clear the loan.
If a person does not clear their student loans, the lender cannot seize their college degree or knowledge. To offset the high risk of issuing such unsecured loans, lenders generally issue higher interest rates when granting unsecured loans.
Why student loan interest rates are so high might be explained by the fact that student loans disbursed for direct subsidized and unsubsidized loans for undergraduates come pegged with a 3.73% interest rate. On the other hand, direct unsubsidized loans for graduate or professional students come with a 5.28% interest rate. Direct PLUS loans for graduate or professional students are the most expensive, with a high-interest rate of 6.28%.
The interest rate for private student loans can hit highs of 14.49% for fixed-rate loans and an average of 12.23% for variable rate loans. These are extremely high financing terms considering the interest rate for a 30-year mortgage average of 2.96%. Additionally, the average auto loan in the US comes with a 3.86% interest rate for new cars.
How is Student Loan Interest Calculated?
While there is no doubt student loans are expensive compared to other loans, it is important to calculate how much interest must be paid for budgeting. That’s the only way you will be able to plan your finances. Figuring out how much interest lenders charge in any loan cycle is pretty simple:
Step 1: Calculate daily interest
Any student loan comes with the principal amount and the annual interest rate. For instance, one could have a $10,000 student loan with a 5% annual interest rate. To calculate the daily interest rate, divide the annual interest rate by 365 (the number of days in a year).
This way, you will end up with the amount of interest rate that accrues in a day from the annual interest rate: For instance, the 5% annual interest rate will amount to 0.000137% (0.05/365) daily interest rate.
Step 2: Calculate daily interest accrued
Equipped with the daily interest rate (0.000137%), it becomes easy to calculate the daily interest accrued on the student loan. Conversely, the interest amount will be $10,000 x 0.000137, which amounts to an interest charge of $1.37.
What this means is that the $10,000 student loan will accrue $1.37 in interest each day for the duration of the loan.
Step 3: Calculate monthly interest charge
The interest accrued monthly would be $1.37 x 30, amounting to $41.10, while the amount of interest accrued in a year will be $493.20 ($41.10 x12).
While calculating interest on student loans, it is important to note that interest in unsubsidized loans starts accumulating immediately after disbursing as there is usually no grace period. In the case of a subsidized federal loan, interest won’t be charged until the grace period is over. With an unsubsidized loan, you can also choose to pay off accrued interest while still in school.
In case of a forbearance whereby payment is paused, interest on the student loan will continue to accrue and will be tacked into the principal amount. In case of economic hardship and deferment, interest will continue to accrue unless you have a direct plus loan from the government.
Does the Federal Reserve Affect Student Loan Interest Rates?
The US Federal Reserve is tasked with providing a safe, flexible, and stable monetary and financial system. Do student loan interest rates change when the FED hikes and cuts interest rates? Yes, whenever the central bank changes the benchmark interest rate, it ends up affecting rates on existing variable student loans as well as loans that might be taken in the future.
Student loan interest rates increase for new applications and variable loans whenever the FED hikes the interest rate. Similarly, if the FED cuts, the interest rate on the student loan would likely go down on the lender offering a much more affordable variable rate.
FED action won’t affect the underlying interest rate or interest payments in the case of fixed interest rates on student loans. The rates are fixed forever and won’t change regardless of what the FED does.
The federal funds rate is the rate banks charge each other whenever they exchange money overnight. Private lenders which issue student loans don’t base their variable rate on the federal funds rate. Instead, they base it on the London Interbank Offered Rate.
On the other hand, Federal student loans are based on the 10-year Treasury Notes. They are determined using a formula set by the FED. Conversely, whenever the yield on the 10-year T-note increases, there will always be an increase in interest rates on long-term debt such as student loans.
How Should a Changing Fed Rate Affect a Borrower’s Financial Behavior?
Interest rate hikes and cuts are one of the monetary policies that the Federal Reserve deploys to try and stabilize the economy. During periods of economic boom, the FED will often hike interest rates, while interest rate cuts often follow periods of economic slowdowns.
The hikes and cuts carried out by the FED go a long way in influencing the borrowing costs in the market. In most cases, the banks and other financial institutions will increase interest rates on variable rates whenever the FED hikes and cut whenever the FED cuts.
Whenever the FED hikes interest rates, borrowers should be extremely cautious. Banks increasing interest rates on variable rates results in a significant increase in interest payments on loans. Therefore, if one has not experienced an income increase to cater to the high-interest payments on loans, there could be a problem. Finances will often be stretched given the new expenses in additional interest payments. Therefore it calls for cost cuts in other things to raise cash to cater to the higher interest payments on loans.
Is Student Loan Interest Rates Increasing?
Student loans are about to get more expensive following the move by the US central bank to hike interest rates in a bid to combat runaway inflation. These loans are poised to increase by 1.26% starting July following a half a percent increase in the federal funds rate.
It will translate to about a 34% increase in undergraduate student loans and a 24% increase in graduate-level loans. PLUS loans will also experience a 20% increase following the 1.26% increase.
The new fixed rates will be
- 4.99% for direct subsidized and unsubsidized undergraduate loans
- 6.54% for unsubsidized graduate loans
- 7.54% for grad and parent PLUS loans
The new rates will affect federal student loans for the 2022 -2023 academic years. However, the new rates will only apply to new federal student loans. Older loans taken are not affected, given that federal student loans are always fixed. Private variable loans, on the other hand, won’t be spared.
The new federal interest rates are poised to rise back to pre-pandemic levels after tanking in the aftermath of the FED cutting interest rates to record levels. At the height of the pandemic, subsidized and unsubsidized undergraduate loan interest rates fell to 2.75% in the 2020-2021 academic years from highs of 4.53% in the 2019-2020 academic years. The rates increased to 3.73% in the 2021 -2022 academic year and are now poised to increase to 4.99% for the 2022-2023 year.
The Student Loan Payment Pause Program and Its Impact on Interest Rates
At the start of the pandemic, put on hold a requirement to pay all federal student loans. With the pause, interest rates were set to 0%, meaning eligible federal student loans did not incur any interest, and the agencies stopped collections on defaulted loans.
While the “payment pause” program was poised to expire in September of 2020, it has since been extended to August 31, 2022. For how long student loan interest rates at 0 will be the order is still an open question after the recent extension to August.
The payment pause affected a majority of the student loan holders, with the average debt obligation dropping by $210. The payment pause also improved borrowers’ credit standing as delinquency rates dropped from 7% to 0%.
Borrower’s credit scores also increased by an average of 30 points. The program also saves the borrowers up to $1.5 billion in interest payments. Once the payment pause program ends, the risk of nearly 8 million people defaulting on payments is high, given the high inflation levels that have seen the cost of living skyrocket.
The new rates on student loans poised to come into effect in July will also make borrowing quite expensive. At last year’s rate of 3.73%, anyone who borrowed a 5,500 unsubsidized student loan ended up paying $55 a month in interest, amounting to $1,497 for a ten-year repayment period. If you borrow the same amount in July, you will end up paying $3.33 more per month in interest, translating to an additional $400 more in the repayment period.
How Does This Affect Existing Loans?
The “pause payment” program means all the existing federal student loans will not incur interest starting March 13, 2020, to August 31, 2022. Any person who makes loan payments during this period will have the amount go directly to offset the principal amount once all the interest accrued prior to the pause is settled.
Bottom Line: Getting the Best Student Loan
It’s no secret that education in the US costs a fortune. While student loans have plunged most people into unending debt cycles, it is nearly impossible to avoid them. The average cost of a bachelor’s degree in a public university is upwards of $80,000, an amount that very few people can raise outright.
For people who cannot secure scholarships and grants, carrying out due diligence on all the options available in the market is essential. Picking the right student loan can make a big difference in repaying after college.
If unsure of what type of loan to go with, it is important to settle on one that offers the lowest interest rate, multiple repayment options and comes with more borrowers’ protections. A federal loan will always check all the boxes.
Federal loans come with fixed interest rates that are lower than private loans. In addition, they come with multiple repayment options and income-driven repayment structures. Direct subsidized loans are tailored for students that can demonstrate financial need. On the other hand, direct unsubsidized is not based on any financial need. The amount that one can borrow depends on attendance costs and financial aid.