For undergraduates and graduates considering student loans to help pay for their education, finding a low interest rate loan is important. Understanding how rates are set and how they potentially change over time can help you decide which loan is best for you. Let’s take a closer look at what determines the interest rate on various types of loans.
Direct Loans
The largest student loan program in the United States is the Direct Loan Program, which is offered directly through the federal government. The formulas for setting interest rates for the Direct Loan Program are determined by Congress. Currently, the interest rate is set as a fixed rate for all loans first disbursed on or after July 1 of a given year and by June 30 of the following year. So, any loan first disbursed during that one-year window will have the same interest rate for the life of that loan.
The fixed interest rate for each federal loan type is set using a base rate, or index, plus an add-on or margin for each loan type. The latest 10-year Treasury note is the index used for new loans first disbursed each year in the July 1 – June 30 timeframe.
| Borrower Type | Index (10-Year Treasury Note) | Add-On (margin) | Fixed Interest Rate | |
|---|---|---|---|---|
| Direct Subsidized Loans | Undergraduate Students | 0.700% | 2.05% | 2.75% |
| Direct Unsubsidized Loans | Undergraduate Students | 0.700% | 2.05% | 2.75% |
| Direct Unsubsidized Loans | Graduate/ Professional Students | 0.700% | 3.60% | 4.30% |
| Direct PLUS | Graduate/ Professional Students and Parents of Dependent Undergraduate Students | 0.700% | 4.60% | 5.30% |
Private Loans
For private student loans, the interest rates will still be based off of a financial index (although the exact index may vary by lender) plus a margin. However, other factors will also go into determining the interest rate on private student loans. The borrower’s credit score (or cosigner’s credit score) is a determining factor in the interest rate assigned to a private student loan. A high credit score may translate to a low interest rate. Another factor that can determine the interest rate on a private student loan is the length of the repayment term. Typically, a longer repayment term means paying a higher interest rate.
Fixed Interest Rates
Private student loan lenders offer you the option of fixed interest rate loans. With this type of loan, the interest rate will remain constant for the life of the loan. Lenders may adjust their fixed interest rates each year for new loans – or even on a monthly basis.
However, once you’ve received your loan, your fixed interest rate for that specific loan will remain the same until the loan is paid in full. Your monthly payment will also remain constant for the duration of your repayment term as long as you are making full principal and interest payments.
Variable Interest Rates
When private student loan lenders set their variable interest rates, they may use a different financial index. Some lenders will use the 1-month where the variable interest rate will fluctuate monthly based on changes (up or down) in the 1-month LIBOR. Other lenders may use the 3-month LIBOR and adjust their variable interest rates quarterly (every three months). As of 2021, the Secured Overnight Financing Rate (SOFR) is starting to replace the LIBOR as a popular index for private student loans. Calculated based on past transactions, the SOFR is considered a less risky rate than the LIBOR.
Finally, other lenders may use the Prime Rate as their index and adjust their variable rates monthly. The bottom line is that your variable interest rate will likely change and your monthly payment will also go up or down based on your rate increasing or decreasing.
So, is any particular type of index better than another when evaluating interest rates from different lenders? You really need to know what the index rate is as well as the margin being added. For example, if you see an offer for an interest rate of “Prime + 1.5%” that might sound pretty good compared to an interest rate of “1-month LIBOR + 4.50%.”
Visually, it just looks like the first rate would be lower. However, if the Prime Rate is 4% and the 1-month LIBOR rate is 1%, both rates would equal 5.50%. It’s always a good idea to look for a lender’s Application and Solicitation Disclosure to see the true interest rate calculations.
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