Why Student Loan Interest Rates Are So High

Americans owe $1.73 trillion in student loan debt. And despite a freeze on interest rates for most of that debt since the start of the coronavirus pandemic, hundreds of thousands of borrowers owe more than what they borrowed to cover their college costs. Many have not even paid even $1 towards their original principal balance.

There are many reasons why so many people are underwater on their loans years after entering repayment. Chief among them are interest capitalization and high-interest rates.

Elsewhere, I explain how capitalized interest increases the total amount you have to pay back. In this post, I’ll explain:

• Why student loan interest rates are so high

• Why federal student loan interest rates are going up

• The difference in interest rates for private vs. federal loans

• How to lower student loan interest costs

The interest rate for private student loans can be high for two reasons. First, there’s no collateral for the lender to repossess or foreclosure. If the borrower misses payments, the lender can’t seize a college degree to repay the loan.

Second, private lenders look at a borrower’s creditworthiness before approving a loan application. College students typically have low income and little to no credit history to qualify for lower interest rates. As a result, their borrowing options are limited to loans with higher interest rates and the need for a cosigner.

The federal government is raising the interest rate for its loans by nearly a percentage point come July 1, 2021. The reason for the increase is related to how Congress sets the rate for federal student loans. Each May, Congress looks to the yield for the 10-year Treasury note at the annual auction. If it increases, Congress raises the fixed interest rate for Department of Education Loans. The opposite happens if the yield decreases.

Current Interest Rates 2021-22 School Year:

• Direct Subsidized Loans: 3.73%

• Direct Unsubsidized Loans (for undergraduate students): 3.73%

• Direct Unsubsidized Loans (for professional and graduate students): 5.28%

• Direct PLUS Loans: 6.28%

While rates are rising, the rates federal financial aid recipients have received in recent years are among the lowest. In the 1990s and early 2000s, interest rates were as high as 8.9%.

Learn More: Reddit student loan questions and answers

What causes the yield to change? The yield for Treasury notes changes based on how investors feel about the economy. The better they feel about it, the fewer notes they buy, which drops the purchase price for notes but raises the yield. Conversely, the worst investors feel about the economy, the more interested they are in buying Treasury notes. Greater demand drives prices up and the yield down.

The significant difference between the interest rate for federal student loans and private student loans is the role of credit. The Department of Education gives all student loan borrowers the same interest rate for the same loans each year regardless of their credit score. Your credit history doesn’t raise or lower your rate.

This is entirely different from the rate charged for private student loans, which are based on credit. As is true with credit cards, mortgages, and auto loans, lenders reward borrowers with good credit scores and good income with the best current interest rates.

One other difference is the option to choose a fixed or variable rate loan. Federal student loans have a fixed interest rate for the life of the loan. Private student loans allow borrowers to choose a fixed or variable rate.

• Fixed-rate loan: the rate is set for the life of the loan. It won’t respond to changes in the marketplace. Consequently, you run the risk of paying more in interest than you could if your rate did respond.

• Variable-rate loan: the rate fluctuates throughout the loan’s lifespan. Variable interest rate loans typically start out lower than fixed-rate loans but will move up or down with the market or index. Many lenders tie variable rate loans to the London Inter-Bank Offered Rate. As the LIBOR changes, so too will the rate of your loan.

Note: The Department of Education previously offered borrowers fixed or variable rate loans. It stopped offering variable rate loans when it ended the Federal Family Educaiton Loan Program. If you consolidate a variable rate loan, the interest rate for your Direct Consolidation Loan will be fixed and based on the weighted average of the interest rate of the loans included in the application.

Private student loans can have lower interest rates than federal loans in two instances:

• refinancing existing loans

• paying for a child’s college education as a parent

Student loan refinancing with a private lender is the only way borrowers with federal loans can lower interest rates. It also allows people who borrowed private loans to pay for their bachelor’s degree the opportunity to get a better rate than they could get when they didn’t have a credit history.

Similarly, parents who are footing the bill for their child’s higher education pursuits and grad students may be able to get a better rate with a private lender than they could get with a Direct PLUS Loan, which has the highest interest rates of all new federal loans.

No matter if you’re refinancing or borrowing for the first time, you’ll need a great credit score and a good income to qualify for the best rates. Making on-time payments is one way your student loans can affect your credit score.

Beware: Refinancing federal student loans removes you from eligibility for federal benefits like income-driven repayment, student loan forgiveness for public service (full-time government and nonprofit employees), and loan cancellation due to permanent disability.

The daily interest that grows on student loans makes it challenging to make monthly payments. Here are some steps you can take to reduce the impact interest has on your loan balance:

• Avoid capitalized interest: Instead of taking a deferment or forbearance during your four years in undergrad and two-plus years in graduate school, make interest-only payments. And if you’ve started repayment in an income-based plan, complete your annual recertification to avoid adding accrued interest to your loan amount.

• Make extra payments: Paying more than the minimum each month will not only help you pay off your loans faster but will also save you money on interest charges. Consider adding more money to your monthly payment or make payments every two weeks instead of monthly.

• Refinance student loan debt: Many lenders offer low-interest rates to people with high credit scores, salaries, and good payment history on their student loan debt. You can use a site like credible.com to compare multiple lenders to see which offers you the best rate. If you have similar offers, give greater weight to lenders that provide the most flexibility with student loan payments and the longest possible forbearance and deferment options.