Have you ever looked at your student loan interest rates and had absolutely no idea what the numbers meant? You are certainly not alone. Before you take the first loan you see, know what these interest rates mean. Later on down the road, this information will become increasingly valuable as you secure a new car loan and even a mortgage.
The first thing to understand about student loans is that their interest rates and fees can be significantly different across lenders. Furthermore, interest rates are generally lower for federal student loans than private student loans.
Take a look:
- Both direct subsidized and unsubsidized federal loans for undergraduates are 2.75% for 2020-2021.
- Private student loan rates for undergrads range tremendously between lenders. Fixed rates start at 4.49% and variable rates at 1.25%. However, their top end is 13.24% and 12.23%, respectively.
There’s a lot of terminology just in that short overview, so it’s worthwhile to make sure you understand what it all means.
Understanding student loan terminology
When you’re looking at loans, you need to understand the language in order to make the best decision.
Here’s a glossary of the most important terms:
- Interest: a percentage of the borrowed amount of money set by the lender that is required to pay back to the lender. Interest accrues daily during the life of the loan.
- Federal: loans made by the federal government that typically come with greater benefits than private loans. They are provided at one interest rate that is set for the term.
- Private: Private institutions like banks and other lenders provide loans at fixed or variable rates that are determined based on the credit of the borrower or co-signer.
- Subsidized: These loans do not accrue interest while the student is in school at least half-time or during deferment periods. Students must complete the FAFSA application each year to prove financial need and qualify for subsidized loans.
- Unsubsidized: The loans do accrue interest while the student is in school. You do not require any proof of financial need for the loan and can borrow more money than with subsidized loans.
- Variable interest rate: This is an interest rate that changes periodically throughout the life of the loan.
- Fixed Interest rate: This interest rate stays the same throughout the loan term.
Average student loan interest rate
The total amount of federal and private student loan debt is $1.5 trillion in the United States. Of that, the average student owes $30,000 at an interest rate of 5.8%. With a 10 year loan term, that works out to about $9,600 in interest.
How current student loan interest rates work
The standards for interest rates among federal and private student loans differ greatly. Federal student loans are mostly need-based, and come with benefits during the payback period of the loan.
Private student loans are credit-based. They offer lower interest rates to students with good credit scores and higher interest rates to those with lower credit scores.
Here’s a summary of the differences between federal student loans and private student loans:
Federal student loans
- Interest rates are “fixed” for the life of the loan – they do not change.
- Most have origination fees charged as a percentage of the total loan amount. In 2019-2020, the origination fee was 1.062% of the principal.
- Interest rates are set by federal law, and are based on 10-year Treasury notes, plus a fixed increase.
- These rates apply to all students independent of their credit history.
- Undergraduate students pay the least to borrow money for college, whereas graduate students and parents pay more.
- Interest rates are capped by the formula from the Congressional Budget Office. For undergraduates, this looks like: 10-year Treasury Yield of 0.70% + 2.05% add-on = 2.75% fixed interest rate for direct subsidized and unsubsidized loans.
Private student loans
- Interest rates can be variable or fixed.
- Most private lenders don’t charge an origination fee.
- Interest rates tend to be based on your credit rating. You’ll get lower interest rates for good credit and higher interest rates for a low credit score.
- Variable interest rates are subject to change monthly or quarterly with no cap or an extremely high cap of 25%.
How interest rates are affected by student loan consolidation
If you want to consolidate your federal loans for one payment, you’ll be given a new weighted average interest rate.
If you want to consolidate your federal and private student loans into one payment, you’ve got a few things to consider before doing so through a private lender:
- Are you receiving any benefits from federal loans such as income-based payments or loan forgiveness?
- Would the payment be lower if it were combined into one payment?
- Would you pay back more interest over the life of the loan by consolidating?
Consolidation tends to be a better option with federal student loan debt since you can maintain the benefits such as income-driven repayment options and student loan forgiveness.
How interest rates are affected by student loan refinancing
Refinancing student loans is another option to consider, especially if you have multiple private student loans. You can refinance both private and federal student loans, and there’s usually no origination fee to do so.
Refinance rates are credit-based, similar to private student loans. Borrowers with excellent credit will receive fixed rates as low as around 4.5% and variable rates as low as 1.5% (but remember that some variable rates can change monthly).
Borrowers with lower credit scores who are refinancing their student loans, on the other hand, can expect much higher interest rates.
Typically you’ll refinance your student loans for the following reasons:
- Lower your interest rate.
- Customize your monthly payments.
- Combine multiple loans to simplify the payment process.
- Choose a new loan term.
- Remove a cosigner.
If you’re thinking about refinancing your student loans, take the following steps to make the most financially sound decision possible:
- Make sure you have a steady income from a full-time job. This signals to the lender you are more likely to make payments on time.
- Check your credit score. This takes into account your payment history on monthly bills, the types of loans and the debt you carry, debt-income ratio and several other factors. Anything above 600 will likely qualify you for a student loan refinance approval. The higher the better of course. Refinancing should only be an option if a lower interest rate is obtained.
- The process of refinancing can temporarily lower your credit score, so keep the entire process timely. Try to complete all the applications to different lenders within a month. This signals to credit bureaus that you’re comparing offers rather than attempting to take out multiple lines of new credit. Lenders perform “soft pulls” on credit when giving you an idea of what their new interest rate will be. “Soft pulls” don’t impact credit score like a “hard pull” will, which is only performed when a final interest rate is given to you.
- Proceed with caution if you have federal student loans. If you refinance with a private lender, you give up benefits such as income-based payments and Public Service Loan Forgiveness. If these protections aren’t something that you think will impact you and you are confident that you will be in a better financial position by refinancing, you can make that choice.
- Explore the options the lender offers if you lose your job or can’t afford your monthly payments. Ask questions like whether interest will accrue if you defer or postpone payments, and what happens if you default on the loan.
- When picking a refinancing interest rate option, variable or fixed, it’s important you take into consideration how often the variable rate is adjusted and if there’s a cap on how high the interest rate can go. Variable rates are usually offered lower than fixed rates, but they are also riskier due to these fluctuations.
- Ask the lender if there are any discounts available on payments, such as automatic debits. Find out if you can resume these discounts in the event you postpone payments, for example.
Tips on how to repay student loan interest
Since most student loan interest accrues while you’re in school, aside from subsidized loans, your loans will be higher when you enter the repayment process than when you originally borrowed the money.
This can be daunting when you’ve just graduated and started paying back your student loans.
Here are some tips to how to repay those loans so you’re not completely overwhelmed by student loan interest:
- Start making interest payments before your grace period ends. The grace period is usually six months after you graduate.
- Make small monthly payments while you’re still in school to avoid interest that accrues from the time you take out the loan. That capitalized interest is added to your balance owing, and the total amount begins to accrue interest after the grace period. If you’re making even low and manageable monthly payments during your years at school (like $25 a month), you’ll chip away at that interest, saving hundreds of dollars.
- Avoid paying the minimum on your loans if possible. Income-driven payment plans do make paying your loan more manageable may be necessary. But they extend the life of the loan and ultimately cost you more in interest over time.
Make sure you are in good financial health overall. It might be tempting to throw all your money at your student loan debt, but remember that there are other factors of financial health that are important too. These include building an emergency fund, paying off all credit card debt, and possibly contributing to a 401(k) or other retirement plan.