Student Loan Interest Rates Explained

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Mark Kantrowitz

By Mark Kantrowitz

June 17, 2020

During our webinar about Student Loans 101 (Borrowing), participants asked dozens of questions. Here are the answers to questions on borrowing student loans. These are the questions on student loan interest rates.

What benchmark are student loan interest rates tied to? 

The interest rates on federal student loans are based on the high yield of the last 10-year Treasury Note auction in May of each year.

The interest rates on most private student loans are based on the one-month or three-month LIBOR index.

Why are interest rates on student loans so high?

Federal student loans are made to borrowers who have a thin or nonexistent credit history, without any security or cosigners. Eligibility is not based on credit scores, debt-to-income ratios, duration of employment or minimum income thresholds. The interest rates are actually low for an unsecured loan, lower than on credit cards and personal loans. 

Federal PLUS loans do require a modest credit check, which looks for past evidence of financial difficulty, such as serious delinquencies, bankruptcy discharge, foreclosure, repossession, tax liens, wage garnishments and defaults. The eligibility criteria do not consider the borrower’s current or future ability to repay the debt.

Private student loans have stricter credit underwriting and often require a creditworthy cosigner, minimum credit scores, debt-to-income ratios, minimum income thresholds and a minimum duration of employment. 

Federal and private student loans have higher interest rates than home mortgages, but that’s because a home equity loan is secured by the home. If you default on a mortgage, you can lose the home. If you default on a student loan, the lender cannot repossess your education. 

The interest rates seem lower on private student loans than on federal student loans. Why would one choose a federal loan?

There are several reasons why the interest rate on a private student loan may be lower than the interest rate on a federal student loan. And there are many reasons a borrower should choose a federal student loan first.

  • Federal loans have better benefits than private student loans. Federal student loans offer subsidized interest, better deferment and forbearance options, death and disability discharges, income-driven repayment and loan forgiveness. Private student loans save money by not offering these benefits.
  • Timing. The interest rates on private student loans reset monthly, while the interest rate on federal student loans reset once a year, on July 1. Therefore, private student loans may catch up to new prevailing interest rates more quickly than federal loans. Ultimately, the fixed interest rates on federal student loans for undergraduate students will usually be lower than the best fixed interest rates on a private student loan.
  • Variable vs. fixed interest rates. The interest rates on federal loans are fixed, while the interest rates on private student loans may be fixed or variable. A variable interest rate may be as much as 3% percentage points lower than the equivalent fixed interest rate. But, variable rates can change monthly throughout the loan term and may increase.
  • Credit underwriting. Private student loans often require a creditworthy cosigner, which can lead to a lower interest rate, while federal student loans do not depend on the borrower’s credit and do not require a cosigner. 
  • Borrowers may not qualify for the low interest rate. The best advertised rates on a private student loan are available only to borrowers with excellent credit. Most of the borrowers will get the highest advertised rate, not the lowest. Typically, less than 10% of the borrowers qualify for the lowest rate.
  • Federal interest rates depend on the type of loan. Federal student loans for undergraduate students have lower interest rates that federal student loans for graduate students, and the Federal Grad PLUS and Federal Parent PLUS loans have the highest interest rates. Borrowers with excellent credit may be able to qualify for a lower private student loan interest rate than on the Federal PLUS loan, but not the Federal Stafford loan.

For private loans, does the interest rate change for the better or worse for the student versus the parent?

More than 90% of private student loans to undergraduate students require a creditworthy cosigner. The cosigner is usually the parent. When there is a cosigner, the interest rate is based on the higher of the two credit scores. If the parent has a better credit score, it will yield a lower interest rate. 

There may also be a slightly better interest rate on a cosigned loan, even when the borrower and cosigner have the same credit scores.

If you pay off the entire loan amount before the first payment is due, do you have to pay any interest?

Yes. Interest accrues during the in-school period and grace period. On a federal student loan, the interest will be capitalized once, when the loan enters repayment. On a private student loan, the interest can be capitalized more frequently, as often as monthly. 

Even if the unpaid interest has not yet been capitalized, it must still be repaid. Payments are applied first to interest and last to the principal balance. So, paying off the entire loan amount will still leave a loan balance due equal to the amount of interest on the loan.

If you return a federal student loan within 120 days of disbursement, you will not have to pay the interest or loan fees. Private student loans do not provide a similar benefit and will charge interest and loan fees, if any, from the date of disbursement.

Are fees and interest on federal loans deductible on tax returns?

Borrowers can deduct up to $2,500 in interest paid on qualified education loans on their federal income tax returns. Qualified education loans include all federal student loans and many private student loans. 

The student loan interest deduction is an above-the-line exclusion from income, meaning that you can claim the deduction even if you claim the standard deduction.

For the purpose of the student loan interest deduction, interest includes loan origination fees, which are treated as accruing over the term of the loan. 

The student loan interest deduction can be claimed based on the interest as it is paid by the borrower. 

If emergency financial aid grants are used to pay the interest on a qualified education loan, that interest is not eligible for the student loan interest deduction. Likewise, for tax-free employer-paid student loan repayment assistance and interest paid using a tax-free distribution from a 529 college savings plan. 

Is the interest on Federal Stafford loans calculated from the onset of when you start school or when you graduate?

Interest accrues on a Federal Direct Stafford loan from the date the loan is disbursed. 

Interest on subsidized Federal Direct Stafford loans is paid by the U.S. Department of Education during the in-school and grace periods, and during other periods of authorized deferment. Otherwise, the borrower must pay the interest. 

If the interest on an unsubsidized Federal Direct Stafford loan is not paid as it accrues, it is capitalized at the end of the in-school/grace period, deferment periods and forbearance periods.

Do federal loans have interest capitalization?

Yes. Interest continues to accrue during an in-school, grace, deferment or forbearance period. If the interest is not paid as it accrues, whether by the U.S. Department of Education or the borrower, it will be capitalized at the end of the deferment or forbearance period. Capitalized interest is added to the loan balance, leading to the charging of interest on interest. 

For those who will consolidate federal student loans, will they get the lower rate that will be reset this July?

Consolidation of federal student loans more or less preserves the cost of the loans. 

The interest rate on a consolidation loan is based on the weighted average of the interest rates on the loans included in the consolidation loan, rounded up to the nearest 1/8th of a percentage point. 

Since the interest rates on federal student loans have been fixed since 2006-07, the interest rate on a consolidation loan will not be based on the current interest rates available for new federal student loans. Interest rates on consolidation loans are also not based on the borrower’s credit scores, credit history, debt-to-income ratios, duration of employment or income.

What is the spread over the 10-year CMT?

The Parent PLUS loan was pegged to the Constant Maturity Treasury (CMT) from 1992 to 1998. 

Interest rates on Federal Direct Stafford loans, Federal Direct Grad PLUS loans and Federal Direct Parent PLUS loans have been pegged to the 10-year Treasury Note since 2013. 

The spreads on top of the high yield on the last 10-year Treasury Note auction in May are 2.05% for undergraduate Federal Direct Stafford loans, 3.60% for graduate Federal Direct Stafford loans and 4.60% for Federal Direct PLUS loans.

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