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Student loans play a large role in US higher education. A report by Forbes shows that about 70% of all students borrow student loans throughout their college lives, and that the average debt owed come graduation time is at an astonishing $29,400.
The ever-increasing cost of a college diploma has brought with it a corresponding increase in the demand for more student loans. As basic economics dictates, an increase in demand will usually lead to an increase in price. In this case, the price or cost of a student loan is the interest rate the lender charges the borrower for use of the funds. A lot of factors go into the determination of a loan’s interest rate, so much so that borrowers may have difficulty understanding it all. Don’t worry, however, as we provide you the 5 most important things you have to remember about your student loan interest rate:
1. Try to get federal student loans
Generally, there are two types of student loans which you can avail: federal and private. Federal student loans are those funded by the US federal government with the assistance of the Department of Education. Private student loans are those made by private lenders such as banks, credit unions, state agencies, and even schools.
In choosing which loan to take, it’s good to consider their differences. Note that a federal loan is usually more beneficial than a private one, as the government is more willing to be altruistic and to take losses for its citizens than private entities who need to churn out profits to avoid bankruptcy.
Federal interest rates are generally much lower, are income-based in their repayment plans, and allow the interest payment to be tax-deductible. In addition, credit checks are usually not required for most federal student loans. As such, many students can acquire these loans and can even use them to improve their credit ratings.
The interest rate that is charged to students on their federal loans is determined by a variety of factors, such as the type of loan, the characteristics of the borrower (e.g., whether the borrower is an undergraduate, a graduate, or a parent and whether the borrower is in financial need or not), and the year when the loan was borrowed.
For example, a federal loan for a student in financial need (i.e., a subsidized loan) that was borrowed in 2014 will be charged a 4.66% interest rate. On the other hand, a federal loan for a student with in a better financial state (i.e., an unsubsidized loan) will be charged a much higher 6.21% interest rate. A PLUS loan, which is a loan given to graduates and parents, for the same period will be charged a 7.21% interest rate. These federal interest rates are generally cheaper compared to private loans.
2. Determine if you want variable-rate or fixed-rate loans
If you do decide on getting a private loan or if no federal loans are available, determine if you want a variable- or fixed-rate loan. A variable-rate loan adjusts the interest rate at regular intervals with the market. So when the market is doing well, the interest rate usually remains low. But when the market isn’t, the interest rate climbs, making your interest payments more expensive.
To determine when you should choose one over the other, you have to consider the financial environment – both for today and tomorrow. Generally, if interest rates are currently low but are expected to increase, then it would be much better to choose a fixed-rate loan. This is because you lock-in your interest rate at the currently low rate, so even if rates rise, you’re not affected. On the other hand, if interest rates are currently high but are expected to decrease, then it would be more beneficial to choose a variable-rate loan. This is because you can take advantage of the eventual decrease in interest rates, compared to being stuck with your fixed rate.
Sallie Mae currently has variable rates between 2.25% to 9.37%, while its fixed rates range from 5.74% to 11.85%.
3. Check if you can reduce your interest rate further
Regardless of what type of loan you choose, it would be prudent to check if you can reduce your interest rate even further. Some companies have a “borrower benefits” program that allow you to lower your interest rates if you meet certain conditions such as a series of prompt payments or making payments via electronic fund transfer.
In addition, students can coordinate with their banks about automatic debits for their interest payments, as this may allow additional interest rate reduction on their federal loans.
4. Remember that interest is usually capitalized
It is generally a good idea to pay the interest immediately when it is due. This is because many student loans (both federal and private) have stipulations that capitalize the amount of unpaid interest into the principal, and thereafter subject the whole amount to interest in the next periods. What happens, as a result, is an exponential increase in your outstanding debt due to the compounding effect of interest rates.
As such, it is important to quickly pay back your interest if your student loan will otherwise capitalize it. In fact, in some instances, it may even be more beneficial to borrow short-term funds from a friend or another entity just to pay the interest, in order to avoid its harmful compounding effect.
5. Don’t just look at the interest rate
While the interest rate is an important factor in choosing which loan to take, it is not the only factor to take into consideration. One thing to check is whether the loan allows for forbearance or deferment options, i.e., the capability of the borrower to temporarily postpone payment. Sometimes, a loan with a low interest rate but with no forbearance or deferment options may be worse than a loan with more options for postponing payment at the cost of a small addition to the interest rate.
Another thing to look out for is death or disability discharges as some loans, while low in interest rates, may not discharge during death or disability, making it more difficult in the long-term to pay back the balance.
Finally, determining whether forgiveness of the student loan can be achieved in the long-term and whether the repayments can be income-based, (e.g., lower payments will be required during hard times like when you are looking for a job) are also important in evaluating whether the loan is right for you.