Student Loan Interest Rates: An In-Depth Guide
April 20, 2019
If you or a loved one are getting ready to go to college, you're probably being presented with a dizzying array of options to finance your education—from federal direct loans, to PLUS loans, to private student loans. Figuring out federal student loans is tough enough, but when you start looking at private loans, you will be presented with a number of different repayment plans, all with different student loan interest rates, monthly payments, and repayment terms.
But don't feel overwhelmed! Purefy has you covered with this in-depth guide. The principles we will discuss are based on loan programs commonly offered by private lenders, but most of the concepts also apply to federal student loans, and even to other types of loans like personal loans.
In this article, we'll go over:
How does interest work on student loans?
The student loan interest rate is the “flashiest” aspect of the loan that lenders like to show off—we all see advertisements everywhere for “great, low rates,” whether it be for a student loan or a new Toyota. Generally speaking, the lower the interest rate, the less you have to pay back the lender, all else being equal. But how does interest accrue on student loans, exactly?
Most student loans use what is called simple daily interest. The loan “principal” is the original amount of money that you take the loan out for, and which you agree to pay back over time. In contrast, the interest is the “extra” that you have to pay the lender, as part of your agreement to borrow money from them.
Simple daily interest means—simply—that you accrue interest on a daily basis, based on the loan balance (“outstanding principal”) on each given day. You pay all the student loan interest off each month, so it doesn't get added to the total balance, except in certain special situations we'll talk about later.
This doesn't mean that you have to pay the lender back a little bit every day. When you first take out the loan, the interest is scheduled into a system of monthly payments, and a portion of each monthly payment goes into paying off the interest you built up over the previous month.
This scheduling is called “amortization,” and this is what determines the amount that your monthly payment will be. Say you take out a $10,000 student loan with a 6% interest rate and a 10-year term (the amount of time you agree to take to pay off the loan). When your loan first gets amortized, the first couple of payments will look something like this:
Amortization schedule: $10,000 loan with 6% interest and a 10-year term
|Payment Number||Principal Balance Before Payment||Interest Portion of Monthly Payment||Principal Portion of Monthly Payment||Total Monthly Payment||Principal Balance After Payment|
As you can see in the chart above, the monthly payment stays the same each month (and it will for all 10 years), but the interest portion of that payment goes down over time. This happens because, as you bring the principal (outstanding balance) down, the interest you need to pay on it goes down, also (a percentage of $9,900 is always going to be lower than the same percentage of $10,000, right?).
As a result, when you first take out your loan, you will likely see that most of the monthly payment is going toward interest, and that later on, once the balance has come down, most of the monthly payment goes toward the principal.
If you're a little nerdy, you may have gotten out your calculator and realized that, on that first payment, the student loan interest of $61.02 wasn't 6% of the principal ($10,000). It was more like 0.61%. That's because your interest rate (the 6% figure we quoted above) is an annual figure.
When your lender sets up your payment plan as in the above example, the interest rate actually gets divided down into a daily amount, and that teensy little daily percentage is what is used to calculate your interest—hence, simple daily interest.
Going further, you may have heard the term “APR” or Annual Percentage Rate. APR basically takes any extra costs that you are responsible for, like origination fees, and converts those costs into a percentage as if they were spread out over the life of loan. That extra percentage is then added to your rate.
But all of the private student loan companies that Purefy works with don't charge any fees, so for those lenders, the APR and the rate are the same (phew).
How does the loan term affect interest?
In the example above, we used a term (short for “repayment term”) of 10 years. If you're comparing private student loan interest rates, you might be presented with terms ranging from 5 years to 15 years, or even more.
The term simply designates the amount of time you are agreeing to take to pay the loan off. And the shorter the term you choose, the higher your monthly payment will be.
Say the original principal balance is a humungous, massive, pie. Maybe it won an award at the county fair, and people came from three counties over just to see it (I hope the same can't be said of your tuition bill…). If you choose a 10-year term, that means you will be making 120 monthly payments, and that big gigantic pie is going to be cut into 120 pieces. If you choose a 5-year term, it's going to be cut into just 60 pieces (60 months), and—you guessed it—those pieces are going to be a lot bigger.
While those lower payments on the 10-year term will look much more palatable than the 5-year term payments, here's the trick to saving money—if you pay the loan off faster, you wind up paying a lot less in interest.
In fact, you will probably find that the loan term you select has a much greater effect on your total life of loan cost than a small change in interest rate does. Remember the chart above? Think about it this way: if it had been a 5-year term instead, the monthly payment would be much larger (bigger piece of pie), but initially, the portion of your payment that goes to interest would be the same (the same percentage of $10,000)—the result is that a lot more money would be going toward the principal.
As the principal goes down faster, the interest you pay each month does the same. Long story short, when you are shopping for loans, the low payment on that 15-year term might look attractive, but make sure you consider the total lifetime cost, also.
One last thing to consider here is that all of Purefy's lender partners do not charge prepayment penalties. Prepayment penalties are assessed to you by a lender when you make additional principal payments over and above your normal monthly payment.
Basically, they are saying, “whatever happens, we're going to get our cut”—the cut being the interest that you would have paid if you followed the monthly schedule. When a lender does not charge prepayment penalties, that means that you can make as many additional payments as you want, whether it be an extra $100 each month, or a large one-time payment of a couple thousand. These extra payments help bring your principal down quicker, and in doing so reduce the total interest you pay over the life of the loan.
What's the difference between a fixed and variable rate?
When you look at the student loan rates a lender offers you, you will likely notice that they offer both fixed and variable rates. Fixed rates are easy to understand – the rate you choose is fixed over the life of the loan, and once you finalize your loan, the rate and your monthly payment will not change.
This is a very attractive option when rates are low, because even if market rates go up, you will always be locked in to the rate you originally were approved for. It also gives an added measure of certainty—you know exactly what your monthly payment will be every month.
Variable rates, in contrast…vary (as you probably guessed). When a lender presents you with variable rate options, the numbers you see quoted are based on current market rates. There are two components of a variable rate. There is one portion of the rate that won't change for the life of the loan—the “margin.” Then, there is an “index rate” to which your loan will be tied.
Usually, student loans are tied to a LIBOR (London Inter-bank Offered Rate) index, which will change at regular intervals (monthly, quarterly, etc.). If you're curious, the lender will have the details in their fine print disclaimers. The basic idea is that, if market rates (the index rate) go up, your loan's rate will go up, and if the market rates go down, your loan's rate will go down.
You will probably notice that, right now, most student loan variable rates appear lower than fixed rates. Just remember, if market rates go up, those rates will go up also.
What you choose will depend on your tolerance for risk. Keep in mind also, that the term length affects how much risk is present. A 10- or 15-year term, for example, is a very long time, and market rates could potentially look a lot different in a decade. And it will be even more time if that 10 years doesn't start ticking until after you graduate!
What student loan repayment plans are available?
Once you choose a lender, you may notice that they have a few different options for how you can pay the loan back. You may also find that each option comes with a different interest rate. How do you tell which are the best student loan repayment plans for you?
The most commonly chosen option for private student loans (but not necessarily the best for everyone) is deferred repayment. With a deferred repayment plan, you are not responsible for making any payments while you are in school, and usually not until 6 months after graduation. This makes it easy to focus on your education and worry about payments later, once you are graduated and have found your first job.
That said, you must keep in mind that interest will accumulate the entire time you are in school, and that once you graduate and enter the repayment period, all the interested that built up will be added into your loan balance (“capitalized”), becoming part of your principal. You then “begin” as if that interest were part of your original loan—you'll be paying interest on the interest.
Have you ever wondered if you can do something to repay student loans while still in school? The answer is yes, if you choose an interest-only repayment plan. With this plan, you won't be responsible for making any principal payments while in school—you only make payments which cover the interest.
This option can help bring down your total interest cost, when compared to a deferred repayment plan. The payment will be more manageable than an immediate repayment plan (more on that, below), while at the same time avoiding the “paying interest on interest” that happens with deferred repayment plans. If you can manage a paid work study program or shelving books in the library, you may find this plan to be an attractive way to reduce your total interest cost. The job might even help you stay out of trouble, too!
The last option that most lenders offer is called immediate repayment. With this type of plan, you will begin making full monthly payments immediately.
This is usually only a realistic option for parents or for graduate students who are studying part-time while maintaining employment. The bright side is, those who can manage the immediate payments will be rewarded with the lowest total interest cost of all the plans outlined here.
How is my student loan interest rate determined?
When lenders decide what rate you will qualify for, it is generally based on a few factors. One of those is your credit history. Most undergraduates haven't established a good credit history (in other words, their credit score is not very high), and almost all will need to apply for a loan with a cosigner.
Your credit history is a record of all the loans, credit cards, and things of that nature you have had, and how good of a job you've done making your payments. Your score also factors in how long you've had loans or credit cards, which is one reason why young people will usually have a lower score. But having a parent with great credit will help you get the best student loan rates.
Another factor that goes into determining your interest rate is the term length on your student loan. You will probably notice that the longer terms seem to have slightly higher rates. The reason for that is that, from the lender's perspective, the longer the term, the greater the chance that something could happen to a borrower, such as a death, job loss, injury, etc.—anything that could result in delinquency or loan default. The lender accounts for this risk by adding a little bit extra onto the rate.
Similarly, you might be eligible for a slightly better student loan rates if you are pursuing a graduate degree or medical degree. This is because the job and income prospects in those professions are a bit better, so the lender sees it as more likely that you will be able to make full payments over the life of the loan—there's less risk on the lender's part, so you are given a price break.
Individual lenders may use other factors that go into your student loan interest rate, but these are the major factors that many lenders will consider.
How can I reduce my total student loan interest?
Let's bring this all together. When you are deciding on a student loan and comparing interest rates, you will have a lot of options to choose from, and you should approach these options thinking about what, if any, monthly payment you can make while still in school, and how quickly you think you can reasonably pay off the loan after graduation. Always keep in mind, also, that you will have monthly payments on each and every loan you take out while in school.
In general, the best strategies to reduce your total “life of loan” student loan interest are:
Choose a payment plan that lets you make interest payments or even additional principal payments while you are still in school
Opt for a shorter repayment term
Comparison shop to find the lender offering the best student loan interest rate on the plan you want
Once you've graduated, focus on making additional loan prepayments which will help bring down the loan principal faster
What's the best way to compare student loan interest rates?
If you've spent any time looking at lender's websites or lender lists that financial aid offices provide to students, you probably noticed that they only give rate ranges, or “lowest” rates, and you can't tell what rate you will actually qualify for without applying.
If you want the best rate on your student loan, you must compare different lenders, and see who can offer you the best deal. The easiest and simplest way to compare rates from multiple lenders is to use Purefy's rate comparison tool.
Using this student loan calculator, you can view prequalified rates from multiple lenders by answering just a few simple questions and providing an estimate of your (or your cosigner's) credit score.
The calculator will then show you rates, and let you compare monthly payments, the loan balance upon graduation, and the life of loan interest cost. That last figure is critical—seeing how the rate and terms affect the total interest cost can be eye opening.