Student loan debt is one of the biggest financial threats to college graduates and young professionals.
With an average balance of $28,650 for 2017 graduates, according to the Institute for College Access & Success, student loan payments can make it difficult to get access to more credit to buy a car or home, not to mention budgeting for other important expenses.
As a result, finding student loans while you’re in school with the lowest interest rates possible is essential. Even a 1% difference can have a significant impact on you for years to come.
How student loan interest works
Interest is effectively the cost of borrowing money, and it’s typically represented in the form of a percentage. In other words, you’re compensating the lender for the risk they’re taking on by giving you money instead of using it on something else.
With student loans, as with other loan types, your interest rate helps determine your monthly payment and the total amount you pay for the debt.
The way lenders determine interest rates can vary. With private student lenders, your interest rate is determined using a risk-based pricing model. This means that the more of a credit risk you pose to the lender, the higher your interest rate will be.
As a result, having a high credit score, low debt-to-income ratio and generally good credit behaviors are essential. In some cases, it’s helpful to have a creditworthy co-signer to improve your chances of scoring a lower interest rate.
While interest rates can vary with private lenders, that’s not the case with federal student loans. With the U.S. Department of Education, all borrowers who qualify get the same interest rate, regardless of their credit situation. Here’s what you can expect through June 30, 2020:
|Direct Subsidized and Unsubsidized Loans
|Direct Unsubsidized Loans
|Graduate and professional students
|Direct PLUS Loans
|Parents and graduate and professional students
A higher interest rate means you’re paying more for the privilege of borrowing money, and with student loans, where often you’re making payments for 10 years or longer, even a small rate difference can cost you thousands of dollars.
For example, let’s say you have the average student loan balance of $28,650 and qualify for a 4.5% rate on your undergraduate loans. With a 10-year Standard Repayment Plan, you’ll have a monthly payment of $297, and you’ll pay $6,981 in interest over the life of your loans.
If, however, you choose a lender that offers a 5.5% interest rate, your monthly payment increases to $311, and your total interest charges spike to $8,661.
The difference can get even more drastic if you choose a longer repayment plan. With the Extended Repayment Plan, for instance, your term is extended to 25 years.
In this scenario, a 4.5% interest rate would give you a monthly payment of $159 and total interest charges of $19,124, while a 5.5% rate would increase your payment and total interest to $176 and $24,131, respectively.
It’s also important to note that certain types of interest can affect you differently. While the Department of Education offers only fixed interest rates, some private lenders offer both fixed and variable rates.
With a fixed interest rate, your rate — and, therefore, your monthly payment — remains the same throughout the life of the loan. With a variable rate, however, the interest rate and your monthly payment can change as market rates fluctuate.
So while you may find a variable rate that’s 1% lower than a fixed rate, that doesn’t necessarily mean you’ll save money. As rates change over time, your variable rate may end up being much higher than the fixed rate, costing you more money. As a result, variable rates are best for borrowers who plan to pay off or refinance their debt within a few years.
How your repayment plan options come into play
Depending on where you get your student loans, you may have different repayment plans available to you. Here are the main ones you’ll come across:
- Deferred repayment plan: With this type of plan, you don’t have to make monthly payments until after you graduate or leave school for other reasons. In most cases, you’ll get a six-month grace period before you start making payments. Depending on the type of loans you have, interest may or may not accrue while you’re in school.
- Immediate repayment plan: As the name suggests, you’ll start making monthly payments as soon as you take out the debt.
- Interest-only repayment plan: With this plan, you’re required to make interest-only payments while you’re in school, but full monthly payments are deferred until after you leave school
If you’re a college student, a deferred repayment plan may sound like the best option. But unless you have Direct Subsidized Loans through the Department of Education, interest will accrue on those loans the entire time you’re in school.
Then, when you graduate, that interest will capitalize and increase your total student loan balance. For example, let’s say you borrow $20,000 throughout your time in college and accrue $3,000 in interest during that time. Instead of your monthly payments being based on the original $20,000 amount you borrowed, it’ll be based on that amount plus the capitalized interest, giving you a new balance of $23,000.
Opt for interest-only repayment
If you can manage it, choose an interest-only repayment plan. While it requires you to make monthly payments while you’re in school, it can save you a lot in the long term. And if you qualify for Direct Subsidized Loans, take them. With this specific loan type, the government will pay your interest while you’re in school.
To help you visualize the savings, deferring $20,000 worth of student loans with a 4.5% interest rate for four years without making interest-only payments will increase your loan balance and monthly payment by $3,602 and $37, respectively.
If your interest rate is 5.5%, the deferment will increase your balance by $4,403 and your monthly payment by $47.
Compare lenders to find the best rate
A lower interest rate on your student loans will not only lower your monthly payment but also save you a lot of money over the life of your loans.
Before you take out student loans, take some time to research your options, and choose the lender with the lowest rates. If you’re an undergraduate student without a credit history, the Department of Education is usually your best bet, especially considering the other benefits you get with federal loans, including income-driven repayment plans and forgiveness programs.
But if you’ve run out of eligibility for federal loans or you’re a graduate student or parent, compare what the federal government offers to private lenders. To help you save time, use Purefy’s rate comparison tool to compare rates and terms from multiple private lenders in the same place.