Due to the fact that education is seen as an incredibly valuable asset, along with college students not having amassed a significant amount of wealth, many would believe student loans to be some of the lowest interest rates around. However, this isn't always the case, and it has many people questioning why student loan interest rates are so high.
Private and federal student loan interest rates have the reputation of being a little higher than other types of 'good debt.' This includes car loans and mortgages.
Generally speaking, why are student loan interest rates usually significantly higher than some other common types of loans? The main reason for this largely comes down to the differences between unsecured and secured loans, which is the same when it comes to how long it takes to get a student loan.
Like student loans, unsecured loans are not linked to an asset that can be used as collateral. At the same time, secured loans are backed with a tangible asset with value and can be used as collateral. For this reason, if a person doesn't pay their auto loan or mortgage, the lender of this loan can seize their car or house.
This cannot be done if a person doesn't pay their student loans. The lender of the loan can't seize a college degree or the knowledge that this particular person has gained from using this loan to study. Thus, student loan interest rates are generally higher than when compared to secured loan interest rates. The reason for this is because the lender's risk is higher when granting unsecured loans as there isn't any or very little collateral provided.
What Are Direct Subsidized and Unsubsidized Loans?
Direct subsidized, and unsubsidized loans are federal student loans that are eligible to students, such as college graduates and undergraduates. These loans are equipped with a fixed interest rate that's set by Congress.
These loans are used as a way to provide money to help cover the cost of tertiary education at a four-year university or college, technical school, career, trade, or community college. This is one of the best ways for those who don't have a history with credit to gain direct finance (money) for their undergraduate or graduate college degrees.
These types of loans are available for undergraduates, graduates, professionals students, and parents of an undergraduate student. However, the interest rates provided for these different individuals vary. These are the statements from July 1, 2019:
· Direct Subsidized and Unsubsidized loans for undergraduates were at an interest rate of 4.53 percent.
· Direct Subsidized and Unsubsidized loans for graduate and professional individuals were at an interest rate of 6.08 percent.
· Direct PLUS Subsidized and Unsubsidized loans for graduate, professional student, and parents of a college undergraduate or graduate student were at an interest rate of 7.08 percent.
These interest rates certainly aren't low. One reason for student loans not having lower interest rates is mainly due to the risk involved in these types of loans. Many undergraduate persons have yet to acquire credit cards and work up a history of credit. Thus, lenders can't judge whether the person can pay back the loan.
Moreover, student loans are linked to any tangible asset that can be taken away if the person doesn't pay their repayments. This, along with the lack of credit associated with applicants, are the primary reasons for the interest rates not being lower.
What Are Private Student Loans?
Private student loans provide applicants with money that's offered by private-sector lenders rather than the federal government. Applicants have the option between fixed and variable interest rates and change at the discretion of the lender's specific underwriting.
Generally speaking, the interest rates offered in the private-sector are lower. These lower rates are mainly due to the private-sector trying to remain competitive against the public sector, as taking out federal loans provides applicants with more protection and benefits.
Undergraduate applicants usually struggle to receive any money from private-sector financial providers. These applicants don't have the necessary credit to meet the requirements that those who are experienced with credit can.
How Have Federal Student Loan Interest Rates Progressed?
There's no doubt that the interest rates on federal loans have fluctuated over the last few decades. However, these rates have been quite steady in the recent years. Congress set fixed interest rates for student loans between the 1960s and 1992. These rates ranged from six percent to 10 percent.
Over these past two decades, the federal interest rates on student loans were dependent on whether these borrowers were in repayment, in a six-month grace period after finishing school, or were still in school.
Until 2006, the interest rates on federal student loans were significantly all over the spectrum. This caused a few problems, which ultimately led to the rates becoming fixed once again after 2006. However, the rates differed based on the kind of loan that was being borrowed—for example, Direct Unsubsidized and Direct Subsidized.
These specified rates hovered between six and seven percent until the recession of 2009. After the 2009 recession, these interest rates fell between three and four percent for student loans for undergraduate students and five percent for graduate students.
Compared to the student loan interest rates in 2018, federal student loan interest rates have taken a bit of a dive. When comparing the 2018 school year with the 2019 school year, the interest rate for the year went down 0.18 percent.
Federal student loans disbursed after July 1 are subject to change as this is when Congress generally sets new federal interest rates. Thus, loans issued after July 1 are equipped with the newly released federal interest rates.
What Is the Difference Between Federal Loan Interest Rates and Private Student Loan Interest Rates?
The interest rates of federal student loans are set by Congress on an annual basis and are based on the 10-year Treasury note. This interest rate is fixed over the entirety of the loan's life.
This means that if a person gets a federal student loan, the rate that was issued with that loan won't change even when Congress sets a new interest rate each year. The interest rate issued by Congress when a borrower receives the loan isn't subject to change when Congress releases and sets the new interest rate for the upcoming year.
However, suppose a current borrower needs to take out an additional federal student loan. In that case, the current interest rate is going to be applied to this additional loan, not the existing interest rate that's being applied to the borrower's existing student loan.
The interest rates applied to private student loans are entirely different. The lenders of these loans hold the ability to determine their own rates that are based on the current market conditions and the borrower's credit-worthiness. In addition to this, the interest rates for private student loans can either be variable or fixed, which is unlike federal student loans.
· Fixed means that the specific rate set at the time of obtaining the loan won't change over the lifespan of the loan. However, this rate may be higher than a variable interest rate.
· Variable means that the interest rates associated with the loan can fluctuate through the duration of the loan's lifespan. These variable interest rates generally start out being lower than fixed interest rates and can change depending on the market conditions, along with other components.
As with most elements in life, there are advantages and disadvantages associated when choosing between a fixed interest rate and a variable interest rate. This choice is highly dependent on the borrower's specific financial picture, along with the proposed interest rate on the particular loan. For this reason, there is no clear answer as to why the type of interest rate is the best one because the choice is going to vary because of the borrower's specific financial position. These fixed and variable interest rates are only available when taking out private student loans.
How Are the Interest Rates of Private Loans Calculated?
As previously mentioned, there are many elements needed to determine the interest rate that depends on the applicant. An example is the applicant's credit-worthiness. The interest rates applied to these private student loans drastically vary among private lenders.
The interest loans associated with private loans, especially student loans, is going to fluctuate with market trends. However, these interest rates are also formulated from additional factors. Unlike when taking out a federal student loan, private lenders are going to look at a number of factors when looking to give out a private student loan. Some of the most common factors include:
Credit History
When starting college, it's common for most students to have very little to no credit history. As a result of this, the lenders considering this student loan are unsure of the applicant's ability to repay the loan. This is largely since students don't generally have any history of paying any loans. The result of this is a higher interest rate as there is more risk involved in issuing the loan.
The School You're Attending
The majority of four-year schooling institutions are eligible for private student loans. However, some two-year colleges aren't suitable for students attending these institutions to get private loans. In addition to this, applicants applying for these loans have to be enrolled in their respective study program at least high-time in order to get a private student loan.
The Finances of the Applicant's Cosigner
Due to the fact that most of the students applying for private student loans are fairly new to debt and aren't in possession of any credit history, these applicants might be required to provide a cosigner with their application.
A cosigner is a person who essentially shares the burden of debt with you. This means that this cosigner is liable to pay back the loan if you can't. In some cases, a cosigner with a strong credit history can sometimes provide the applicant with a lower interest rate on private student loans. However, this is highly dependent on the lender of this private student loan.
In addition to these factors, as mentioned earlier, the benefit of choosing a student loan from a private student loan provider is that the applicant can shop around and look for the best interest rate from a variety of different private student loan providers. Unlike receiving a federal student loan, the applicant is only given the single interest rate annually set by Congress each year.
Interest rates are going to vary from each lender. This is because of each private loan provider's underwriting criteria, along with the applicant's financial profile.
What Are the Procedures for Managing High-Interest Rate Student Loans?
As previously stated, interest rates of student loans are generally higher when compared to other types of loans. Due to this, many students with student loans struggle to make their monthly student loan repayments because of this high interest. If this is the case, there are many alternative options that should be considered. Here are some of the most common and effective alternatives:
Federal Repayment Plans
An applicant who received a federal student loan can get many federal repayment plans. When taking out such a student loan, the borrower is automatically placed on the Standard Repayment Plan. The only exception for this is if the applicant chooses another option. The conditions of the standard repayment plan split the repayment over a period of 10 years.
The other options available for federal student loans extend the term of the repayment. Doing this can make loan payments more manageable for borrowers. However, this extended payment period also means that the borrower's total amount paid back is increased. This is because the borrower is going to be paying more in interest over the lifespan of the loan.
Borrowers who are financially struggling to make the relative repayments while on the Standard Repayment Plan may consider getting put on another payment plan available to federal loan borrowers. This includes Extended and Graduated payment plans, along with other income-driven payment options.
Federal borrowers have the option of choosing between five different income-driven plans for repaying their loans. Here is some basic information associated with each one:
· Revised Pay as You Earn (REPAYE): This plan details that the borrower's payments are going to be 10 percent of their discretionary income each month. This amount for the repaying of the loan is going to be recalculated every year based on the income amount and the size of the family.
· Pay as You Earn (PAYE): This option is very similar to the REPAYE loan repaying option. Ten percent of the borrower's monthly discretionary income is going to be taken toward repaying the federal student loans. However, it is never going to be more than the borrower would be paying while on the 10-year standard plan.
· Income-Based Repaying Plan (IBR): Borrowers need to have a high debt to income ratio in order to qualify for this plan. The monthly repayments are going to range between 10 and 15 percent of the discretionary income of the borrower and are going to be reevaluated each year. The biggest difference between the plan and the PAYE and REPAYE is the high debt to income ratio.
· Income-Contingent Repaying Plan (ICR): The policies under the ICR plan are either 20 percent of the borrower's discretionary income or the amount the borrower would pay on a repaying plan with fixed payments made over a 12-year period and is adjusted in accordance with the borrower's income.
· Income-Sensitive Repaying Plan: This option stipulates that the loan payments are going to be based on the borrower's annual income. The condition with this plan says that the borrower's entire loan amount is going to be repaid over a period of 15 years.
In order to qualify for these repaying plans, the borrower needs to meet specific requirements. In addition to this, borrowers of private student loans don't get to take advantage of the option of these repaying plans mentioned above.
Why Is Debt-to-Income Important?
A person's debt-to-income ratio, or DTI, is incredibly important as it's used by potential lenders as a way to determine if the particular person can afford to take out any more credit. This is a common practice when taking out credit cards. A person won't receive the wanted credit if the ratio is not low enough.
People looking for different financial support need to try and maintain a low DTI ratio to ensure best that they receive the necessary credit that they desire.
People can also receive a relatively low-interest rate or good repaying period, longer than a 10-year period, on loans for undergraduate, graduate, and professional college individuals. However, these are very uncommon exceptions as the paying period is generally not lower than a 10-year period.
Federal Student Loan Forgiveness
In some cases, borrowers may qualify for forgiveness in some or all of their federal student loans. This forgiveness is sometimes considered to be a form of financial aid. This loan forgiveness is available under some circumstances. A few of these circumstances are described below:
Public Service Loan Forgiveness
The borrower is eligible to get some form of student loan forgiveness if he or she works for the government or qualifying non-profit selling products and services. It's important that borrowers aren't selling these products and services for their own personal gain but rather for a charitable cause.
The borrower needs to have made 120 qualifying on-time payments on the loan and typically work full-time for the organization. However, with all that being said, many applicants, unfortunately, find the process of applying for such loan forgiveness exceptionally challenging. In addition to this, not all non-profit or government forms of work qualify for this loan forgiveness.
Teacher Loan Forgiveness
Teacher Loan Forgiveness is very similar to Public Service Loan Forgiveness. This forgiveness applies to teachers who are working full-time and have been doing so for five years or more in a qualifying low-income school in order to get forgiveness on their federal loans. This type of forgiveness says that borrowers may receive up to $17,500 on your Direct Unsubsidized and Subsidized financial loans for the borrower's college education fees. However, this only applies to borrowers who fit the conditions described above.
In addition to this, these student loan forgiveness plans are only available for federal student loans. Borrowers of private student loans are able to apply for this forgiveness.
All of these loan forgiveness options have an incredibly strict application process, and the program requires a lengthy commitment from all of its federal student loan applicants.
Pursuing loan forgiveness on a federal loan may require a considerable amount of attention to the details required as the forgiveness application process comes with many program requirements that are based on the conditions of each forgiveness plan. These requirements need to be met in order to receive loan forgiveness.
What Is Forbearance?
Forbearance is a protection policy give to all those who take out federal student loans. This forbearance says that there is a legal right being exercised, which enforces that the repaying of a particular debt is refrained. Thus, a person isn't forced to pay back a loan to the federal government or department of education if they don't pay back the entire amount in a 10-year period, for example. This, along with other features, make federal loans very desirable and is the reason why many people take advantage of federal student loans.
This isn't the case for private student loans. Those who take out private student loans instead of federal loans don't gain this protection. Thus, the money owed by this individual may drive them into debt if they don't pay the necessary cost and fees, such as the loan as a whole, along with the interest fees associated with this loan and any other relative fees included in terms of the loan.
Refinancing Student Loans
It isn't uncommon for loan borrowers to struggle with finances due to the high-interest student loan debt. This can become even more problematic if these borrowers don't qualify for one of the federal financial problems that have been described above. In cases like this, it may be the right time for these borrowers to consider their options and make decisions on refinancing.
Refinancing student loans is one way of potentially receiving a lower interest rate on the borrower's monthly repayments.
There are a variety of factors that vary from the loan provider. However, a borrower may be a strong candidate for a student loan refinancing if he or she has the following:
· The credit score that the borrower applied when the student loans were first taken out has improved. Unlike when the borrower first took out the loans, they may now have a well-established credit history, as they may have taken out credit cards and other debt. Thus, these lenders now have a credit score to look at, which reduces the risk if they have a good credit score. If the borrower has never missed one of their loan repayments, and they are gradually growing their credit score, the borrower may qualify for a lower interest rate.
· The borrower has a stable income. Being able to display a consistent income to private lenders may work in the borrower's favor, as it helps make the borrower look like a less risky investment when it comes to paying back the loan. Based on this, it can also help borrowers receive a lower and more competitive interest rate.
All of the student loans issued by the federal government and department of education after 2006 were provided at a fixed student loan interest rate. In contrast, private refinancing may offer fixed or variable interest rate fees.
All borrowers should be mindful of this when they refinance with any private lenders. This is largely because borrowers may receive fixed or variable rate options, and their choice is going to significantly depend on the borrower's financial position. Borrowers should understand each of these elements to identify which one makes sense for their particular financial situation.
In addition to this, a borrower should take note that they have to give up all federal student loan protections and benefits. This includes forbearance and income-driven repaying plans. Due to this, refinancing isn't going to be the best option for everyone. However, it may help a qualified person secure lower interest rates. Along with this, the person may be able to improve their credit and get out of debt due to the incorporation of a lower interest rate.
For more information regarding student loans, Simple IRAs, Traditional IRAs, ROTH IRAs , or a 401k, contact the Pittsburgh wealth management firm, The Kelley Financial Group.
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The content is developed from sources believed to be providing accurate information.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
