As you hatch a plan to pay down your student loans, it’s important to understand how the interest rates on your loans impact your total costs. One of the biggest factors to consider is whether your student loans offer a variable interest rate or a fixed interest rate.
With a variable interest rate, the interest you’ll pay can change over the life of the loan. Generally speaking, the variable rate on student loans increases or decreases along with a base rate such as the LIBOR or prime rate.
The benefit of carrying loans with a variable rate is that you’ll normally enjoy a lower rate (and proportionally lower loan costs) at the beginning of your loan. If the prime rate stays low for a long enough stretch of time, you may even experience lower interest costs throughout the life of your loan. Of course, the opposite is also true. If interest rates surge after you begin repayment on your variable rate loan, you could pay a lot more interest over time. One more factor to consider with variable rate loans is the fact that your payment isn’t fixed; as your interest rate fluctuates, your payment changes, too.
Fixed-rate loans offer a more predictable path. When you borrow money with a fixed interest rate, you’ll pay the same amount of interest and the same monthly payment throughout the life of your loan. While you may pay a higher interest rate at times, the fact your loan payment never changes may give you peace of mind.
Federal student loan rates are always fixed and easy to qualify for regardless of credit history. However, the interest rate you’ll pay on federal loans can vary heavily depending on the type of federal loan and when it was disbursed.
Since federal student loan interest rates are determined by Congress, they tend to offer good value for student borrowers. The government uses a special formula to determine rates for all federal loans. For undergraduate loans taken out after July 1, 2016, they add 2.05 percentage points to the rate for new 10-year Treasury notes. For federal direct loans for graduate students, they add on an additional 3.6 percent. Meanwhile, rates for PLUS loans are determined by adding 4.60 percentage points to the 10-year Treasury note. While interest rates on federal student loans can change each year, it’s important to note that these rates are fixed for borrowers.
Unlike federal student loan interest rates, interest rates from private lenders are individually determined and not influenced by the government. Since they are offered through private companies, they can also vary tremendously between various providers.
Private lenders offer both fixed-rate loans and variable rate loans, the latter of which can present a good value in today’s economy. Because interest rates have been lingering near historic lows for the past few years, current variable rates on private loans have become especially attractive to student borrowers.
However, fixed-rate loans offered through private lenders can also be competitive with federal loans. This is partly because the interest rates themselves can keep up, but also because private loans often come with fewer out-of-pocket fees. For example, federal PLUS loans charge an upfront disbursement fee of 4.276 percent for loans disbursed on or after October 1, 2016 and before October 1, 2017. This fee isn’t charged by private lenders.
Before you decide between private and federal loans, make sure to compare not only interest rates, but added fees as well.
Whether you hope to pay your loans off early or just want to keep track of your progress, it’s important to understand how student loan interest is calculated. The basic formula you need to know and understand looks like this:
Interest rate X Current balance / Number of days in the year = Daily Interest
Now we’ll put this formula into practice. Let’s say you have the average amount of student loan debt for 2016 college graduates, which was $37,172 according to U.S. News and World Report. Your interest rate is fixed at 6 percent. Your daily interest charges would follow the formula and look like this:
.06 X $37,172 / 365 = $6.11 per day
While $6.11 per day may not seem like a lot, keep in mind this interest accrues daily. Over the course of a 30-day month, you’re paying $183.30 at this rate. Over twelve months, that’s $2,199.60.
With that in mind, let’s look at one more example. Imagine you owe the same $37,172, but enjoy a fixed 4 percent interest rate instead. Your daily interest charges would look like this:
.04 X $37,172 / 365 = $4.07 per day
That works out to $122.10 over 30 days and $1,465.20 over the course of a year.
The formulas shared above are for illustrative purposes only. They don’t take into account the fact that your interest charges will slowly decrease as you pay down your balance, nor do they show the impact you can make with additional payments.
What they do show, however, is just how big a part your student loan interest rates play when it comes to the long-term costs of your student debt.
If your student loan interest rates aren’t as competitive as they should be, refinancing or consolidating your loans can be a smart option. Under the right circumstances, you could secure a loan with a lower interest rate and better terms. And since shopping for a new loan and comparing your options is 100 percent risk-free, you have nothing to lose.
In addition to having the convenience of one loan and one monthly loan payment, instead of multiple loans/multiple monthly payments, borrowers may also be able to lower interest rates on their educational loans through loan consolidation or refinance. Options available include Direct Loan consolidation through the federal government program or loan consolidation through a private lender to refinance student loans at a lower rate.
Note that it’s always wise to shop around for the best student loan refinance or consolidation rates and make sure there are no application, origination or prepayment fees.