If The Federal Reserve Raises Interest Rates, Private Student Loans Will Get Even Costlier
Posted By Donna Fuscaldo on November 11, 2015 at 8:47 am
Talk of an interest rate hike by the Federal Reserve has been on the lips of investors for months now. But with expectations growing that the Fed will move to increase interest rates early next year, many people are left wondering what will happen to their student loan bills. After all, if interest rates increase, it will make the cost of borrowing more expensive.
However, as it turns out, it’s not that cut and dry for student loan borrowers. It all depends on the type of student loan they hold and when they took it out. “Most economists are forecasting a change in December and another one in March,” says Fred Schebesta, Director and Co-founder of Finder.com, an Australian personal finance comparison site that is launching in the U.S. “The rate increase will likely be .25% each time, and there’s a likelihood that rates will keep rising after that.”
But that doesn’t mean student loan borrowers will automatically be impacted. When it comes to student, loans there are two types. There are federal loans, which are backed by the government under the Department of Education and, as of 2006, have a fixed interest rate. That means if rates go up, the interest rate on the loan won’t change. Then, there are student loans that people take out from private lenders, which in many cases are variable. That means the interest rate on the loan changes along with rates in the market. If students have a federal loan from 2006 on, an increase in interest rates won’t matter. But for existing private loans, higher rates could mean a higher monthly payment.
Private student loan borrowers to pay more
Let’s say you have private student loan balance of $40,000 that has a twenty year term and an interest rate of 12%. If interest rates go up two basis points, or .50%, over the life of the loan, you will likely pay $3,367 more, says Schebesta. That might not seem like a lot of money, but if you are already struggling to pay down your student loan debt, an increase of any size is going to hurt. If you have a $100,000 loan you are paying back to a private lender, you will face a higher increase over the life of the loan if and when interest rates rise.
In the case of federal loans, whether or not borrowers face an increase isn’t dependent on the Federal Reserve raising interest rates but on the ten-year Treasury note yield, which is set every May, says Joseph Orsolini of College Aid Planners. This past May, for example, the interest rates on new federal student loans fell to 4.29 percent from 4.66 percent when the ten year Treasury note yield was set. Direct loans for graduate students decreased to 5.84 percent from 6.21 percent while the rates on the PLUS loans went to 6.84 percent from 7.21 percent.
But for borrowers who haven’t paid back a federal loan prior to 2006, loans could still have a variable rate, which means they could see an increased payment if the Fed raises rates. For borrowers new to the private student loan market, any increase in interest rates is going to make borrowing money that much more costly next year.
Refinancing could be an option against rising rates
When it comes to borrowers who have existing private loans, there are things they can do to cushion the blow of an interest rate increase. For starters, they can try to pay down as much of their debt as possible now to reduce the amount that will get hit with a rate increase. Another choice is to try to refinance their private loan into a fixed-rate one. That’s easy to do for someone who makes a good income and has no trouble paying back their loans. But for struggling borrowers, getting a refinance may not as easy. because private lenders are looking for good credit scores and a good debt to income ratio in order to approve a refinancing.
Frustrated borrowers could push back
Another byproduct of a Fed rate hike, at least on the private student loan side, could be pushback from cash-strapped borrowers and potential borrowers that may result in some changes, says Schebesta. For instance, there is already a cap on the amount students can borrow in federal loans. Perhaps the same will eventually apply to private lenders as well. Not to mention, college-bound students who are well aware that college degrees are becoming a bit of a commodity may try alternative ways to get an education, like trade schools or apprenticeships. “Students who are facing massive loans can see the writing on the wall,” says Schebesta. “If you end up with $100,000 in student loans that you are paying back at 12%, that can take twenty years to pay off. But if they borrowed $100,000 and bought a piece of real estate, at least they would end up with some sort of asset, as opposed to a college degree.”