Why Is Student Loan Interest So High?
March 24, 2020
Student loan interest rates represent part of the cost of borrowing money for your college education. And while they’re relatively low compared with other loan types, including credit cards, personal loans, and other short-term debt, they’re typically higher than mortgage loans and some auto loans.
What’s more, student loan repayment terms can be stretched out as long as 30 years, which means that you could be paying interest on your debt for decades.
But how are student loan rates determined, and what can you do to reduce how much you pay in interest charges? Here’s what you need to know.
How student loan interest rates compare
If you’re comparing student loans with other loan types, they’re more expensive than some but a lot cheaper than others.
For example, mortgage and auto loan rates can be much lower than student loan rates because they’re secured debts — this means that the lender has collateral in the form of a home or vehicle, which it can sell to satisfy the debt if you default.
On the other hand, personal loan and credit card interest rates are typically higher because they’re unsecured, and they don’t have the same bankruptcy protections that student loans have. While you can freely include personal loan and credit card balances in a bankruptcy filing, you’ll have a hard time doing the same with student loan debt.
What determines student loan interest rates?
Student loan interest rates may seem somewhat arbitrary, but there are actually some good reasons behind them.
Exactly how are student loan rates determined, though? It depends on the type of loan.
Federal student loans
Federal student loan interest rates are set annually by Congress, and they’re primarily based on the high yield of a U.S. Treasury note auctioned in May of each year. For the 2018-19 school year, the interest rate for undergraduate loans was 5.05%, but that dropped to 4.53% for the 2019-20 school year because the cost of government borrowing went down over that time.
Over the previous decade, undergraduate loan rates have ranged from 3.4% to 6.8%, depending on the year.
For graduate and professional loans, interest rates are 6.08%, and Parent PLUS Loans have a 7.08% interest rate. There is no official justification for these higher rates, but it’s noteworthy to know that Parent PLUS Loans were originally designed for high-asset families who could not cover their expected family contributions with current income, but the program has been expanded beyond that original mission.
Private student loans
Unlike the U.S. Department of Education, private lenders require a full credit check when you apply for a private student loan. Because these lenders function differently than the government, they provide a range of interest rates for all borrowers, based on creditworthiness. This arrangement is called risk-based pricing.
When you apply for a loan, the lender runs a credit check and uses your income information to determine whether there’s a risk that you’ll default on loan payments. If your credit score is too low or you have enough negative items on your credit report, you may not even get approved for the loan.
But if your credit situation is good enough to get approved, your interest rate will reflect the amount of risk the lender considers it’s taking on by lending money to you.
In other words, the lower your credit score and income, the likelier it is that you’ll have a high interest rate.
How to reduce your student loan interest rates
Depending on the type of student loans and your credit situation, you may or may not have many opportunities to get a lower interest rate on your debt. However, it’s important to know the options that are available.
Federal student loans
When it comes to federal student loans, there’s no way to reduce your student loan interest rate because they’re fixed for all borrowers based on the loan type. If you’re a parent, however, you may choose to encourage your student to apply for loans because those carry lower interest rates than Parent PLUS Loans.
If you consolidate your loans with the Department of Education, your interest rate will actually increase slightly instead of going down. Your loan servicer will take the weighted-average rate from all the loans you’re consolidating and round it up to the nearest one-eighth of a percent.
You can, however, refinance your student loans with a private lender and potentially get a lower interest rate in the process. Private lenders can offer both fixed and variable interest rates that are lower than what the federal government charges. If you qualify on your own or with a cosigner, you may be able to save money on interest.
If you can’t refinance, you can reduce your monthly payment with one of the Department of Education’s income-driven repayment plans. These plans extend your repayment term and lower your monthly payment to 10% to 20% of your discretionary income.
Private student loans
If you need student loans for school, you’ll typically get a lower interest rate and more benefits with federal loans. However, if you’ve exhausted your allotment for federal loans, private student loans can be a good way to bridge the gap.
Before you apply, take some time to shop around and compare several lenders to see what kind of rates they have to offer. With Purefy’s Compare Rates tool, you can view multiple rate offers from top lenders based on a soft credit check, which won’t affect your credit score.
While it’s possible to get approved for private student loans on your own, having a creditworthy cosigner apply with you could improve your chances of getting approved and also of scoring a lower interest rate.
If you already have private loans, you may be able to get a lower interest rate through refinancing.
The bottom line
Student loans can feel like a significant financial burden, but it’s possible to save money as you work on paying off yours. Understanding how student loan interest works and what you can do to reduce your interest rate and monthly payment can make it easier to afford your payments and even eliminate your debt faster.