In the United States today, more than 66% of students are paying for their education with loans, in full or in part. And with those loans come interest rates, some of which are set to double in July. But do students really understand what that means? Financial aid experts suggest that they don't, but they should.
The interest rate for Stafford loans is set to double in July if nothing is done to stop them. We've been here before: last year, just days before the rates changed, Congress voted to extend low interest rates for another year. But at a cost of $6 billion in lost revenue each year, they've been encouraged not to do it again, allowing rates to jump from 3.4% to 6.8% starting July 1.
This jump isn't exactly a rate double, though. Rather, it's a reset. Barry Simmons, director of university scholarships and financial aid at Virginia Tech, points out that in 2007, student loan interest rates were exactly the same as they'll likely become on July 1: 6.8%. It was only with 2007 legislation that they gradually dropped to the current rate of 3.4%. But, says Simmons, "loan limits were lower by law, so the impact was not as great as it will be. Student borrowers with subsidized loans will pay more interest in repayment."
What happens if Congress allows student loan interest rates to jump back up to 2007 levels? "Unfortunately, not all students understand interest rates and how that impacts loan repayment amounts," says Simmons. "And borrowers sometimes forget that even the subsidized loan begins accruing interest six months after they cease to be a half-time student."
Financial aid consultant Pam Rambo agrees that most new college students don't really take the time to consider the implications of interest rates on loan payback: "The students I work with are high school and college students, and most of them have little immediate interest in interest rates or how loan payback works." Rather, students are more focused on near-term effects, like meeting college costs.
If you're one of these students with limited attention for interest rates, what is it that you don't know? And what exactly will happen if your interest rate doubles?
How Interest Rates Affect Final Payouts
Your interest rate affects not just the size of your monthly student loan payments, but also the total amount you'll have to pay, which also means it may take you longer to repay the loan. "The higher the interest rate, the higher the payment and total amount of debt the student will owe," says Rambo.
For students who borrow the Stafford loan average of $8,230 with a loan term of 10 years, total interest paid at 3.4% would be $1,489, and the cumulative amount paid would be $9,719. But at a rate of 6.8%, that total jumps to $11,365.39, with total interest paid at over $3,000.
A difference like that can have a major impact on your life after college when the student loan bills start rolling in. Rambo warns, "A high interest rate can mean that a student loan payment could keep (someone) from being able to afford to live on their own or purchase a car after graduating from college."
The loans set to double their interest rate, subsidized Stafford Loans, are hardly the problem for most new grads, though. While students stand to pay back thousands more in interest over the life of these federal loans, most loans, including unsubsized Stafford Loans and parent PLUS loans, are already at a rate of 6.8% or higher.
For students who need more money for school than the federal government is willing to lend them, private student loans are available, but they come at a high cost: with Sallie Mae, variable interest rates can be as high as 9.37%, or 11.85% for fixed rates. For an $8,230 loan at 11.85%, the total interest paid reaches $5,854, with cumulative payments at $14,084. That's almost double the original loan amount, and graduates are saddled with this debt for 10 years, or more with deferment, default, or consolidation.
A New Plan for Federal Student Loans
Rather than enacting another delay in the interest rate hike, the White House has a different plan this year, which would make all new student loans variable from year to year.
Variable rates are common among private student loans, and with those loans, rates are reset each year, potentially doubling or tripling over the life of the loan. But variable rates under the proposed federal student loan program would be handled differently, with a rate that varies from year to year for new loans but remains fixed for the life of each loan. That means you may not be able to predict what your interest rate will be before you go to college, or if you take out a new loan while you're in school, but you'll know what you're in for once you've signed on the dotted line.
Variable private student loan rates are typically tied to either LIBOR or prime rates, the rate at which banks can borrow from each other, and the rate that banks offer their best customers, respectively. And they will usually have an added percentage, as well as a cap. Under the new proposal, federal student loans would be offered with a similarly tied rate based on the 10-year treasury yield, plus 3%. As of mid-April 2013, student loans under this arrangement would be 4.72%, higher than the current subsidized Stafford 3.4% but much lower than the future 6.8%.
What This Means For Students and Their Families
Whether interest rates for federally subsidized loans jump to 4.7% or 6.8%, they're still the best choice for education loans. Even though private student loans may reach rates as low as 2.25%, federal subsidized loans offer distinct advantages, including deferment while you're actively in school, income-based repayment, and free insurance that cancels your loan if you're killed or disabled. You may even be able to have your debt forgiven if you meet certain criteria, and unlike some private loans, federal loans do not charge a penalty for repaying early.
When considering private loans, Rambo recommends that students and their families "carefully consider the loans available to them before signing on the dotted line," taking advantage of loan counseling and financial literacy programs available through their school. Rambo also suggests working with financial planners, as well as discussing your options with the credit union or bank where you have an account. In addition to interest rates, she urges students to consider all of the loan aspects, including the repayment period, income sensitive repayment options, and loan cancellation or forgiveness options.
Online students aren't left out of these resources, either, and they may even enjoy smaller loans by saving money on room, board, and travel expenses. "Online students have the same support services available to them as students on campus through the campus financial aid office. Students who attend classes online should establish a relationship with financial aid staff at their college," recommends Rambo.
If you find that after graduation, or even years down the road, you're having trouble making your student loan payments, you can choose to consolidate them. The advantage is that you'll have a single monthly payment rather than multiple ones, and that monthly payment may be lower if you choose to extend the repayment term. But that means you'll pay more in interest over time, and you'll be paying on the loan for a longer period, as well. And you may lose out on other advantages of maintaining your original loan.
Federal loan consolidation uses a weighted average to determine your consolidated interest rate, meaning that a loan portfolio with $8,000 at 3.4% and $10,000 at 6.8% will have an interest rate of 5.375% on the balance, offering no interest savings. By tying them together, you also miss out on the opportunity to aggressively pay down the higher interest rate debt first.
Simmons says, "Consolidation may not alwasys lower interest rates, and could even increase the amount of interest paid in total." Rambo agrees that student loan consolidation may be a risky proposition. "Students can lower interest rates through student loan consolidation programs, but some of the protections and rights that students enjoy with their existing loans could be lost when they consolidate," she says.
Loans as a Last Resort
Of course, the best student loan is the one you don't have to take at all. Rambo recommends that students exhaust all other options before considering loans, including applying for scholarships, setting aside savings, considering college cost, and going to school locally or online to avoid room and board fees.
We don't yet know what the future holds for federal student loans. But we do know one thing for sure. Student loans are a big decision that's likely to follow you around for at least 10 years. Before you take the plunge with a new student loan, consider this: You aren't just borrowing for an education. You're changing the course of your life, thousands of dollars at a time.