Interest rates on private student loans are set by each lender, not the federal government. The interest rates may be fixed or variable. Private student loans may be offered by commercial lenders and state loan agencies.
Interest Rates Based on Credit Scores
Private student loans are credit-underwritten, with the credit scores of the borrower and cosigner affecting both eligibility and the cost of the loan. Usually the credit decision and interest rate are based on the higher of the two credit scores. So it may be beneficial for borrowers with good credit to apply with a creditworthy cosigner to get a lower interest rate, even if the borrower could qualify for a private student loan on their own.
The interest rates might be grouped into five or six tiers corresponding to ranges of credit scores, with the best credit scores getting the top tier (lowest) interest rates. In most cases less than 5% of a lender’s borrowers will get the lowest interest rates.
Typically, a borrower’s credit scores decrease each year since the borrower’s credit utilization increases. This leads to a higher interest rate. The interest rates reach a peak by the time the borrower graduates.
Variable Interest Rates
On a variable-rate loan, the interest rate is the sum of a variable-rate index, such as the LIBOR index or the Prime Lending Rate, plus a fixed margin based on the credit scores. Since the LIBOR index increases more slowly than the Prime Lending Rate, such loans may be better for the borrower long-term.
Borrowers sometimes get confused by the interest rate formulas for a variable interest rate. An interest rate of LIBOR + 6% is not a fixed 6% rate. If the LIBOR index increases from 0.25% to 5.5%, the interest rate on a LIBOR + 6% rate loan will increase from 6.25% to 11.5%.
Finding the Least Expensive Loan
Students should consider borrowing from federal loans first, since federal student loans are cheaper, more available and have better repayment terms. Federal student loans offer income-based repayment and public service loan forgiveness, which are not offered by private student loan programs.
Most private student loan programs do not provide up-front pricing, so the only way for a borrower to know the interest rates on a loan is to apply. It is generally a good idea to shop around, applying to several loan programs. The lender with the lowest advertised rate is not necessarily the lender who will offer the specific borrower his or her best rate. Borrowers should apply to several loan programs, including at least one state loan, one loan from a larger lender and one loan from a less well-known lender.
Borrowers sometimes worry that shopping around for the best rate will affect their credit score. So long as the applications occur within a short space of time, it will be treated as a single hit to the borrower’s credit score. The credit reporting agencies understand that the borrower is seeking a single loan, not multiple loans.
Cosigners are Co-borrowers
Note that a cosigner is a co-borrower, equally obligated to repay the debt. The cosigned loan will show up on the cosigner’s credit history and will be treated by lenders as though it were the cosigner’s loan. For example, parents who have cosigned their child’s private student loans sometimes find it more difficult to refinance their mortgage because of the cosigned loans.
Student Loan Interest Deduction
Up to $2,500 total in interest on federal and private student loans may be deducted on the borrower’s federal income tax return each year. The deduction occurs as an above-the-line exclusion from income and so may be claimed even if the borrower doesn’t itemize deductions. This reduces the cost of the loan, the equivalent of a small reduction in the interest rate.
Private Student Loan Discounts
Lenders sometimes offer a variety of discounts on the terms of the loan to encourage particular types of borrower behavior. The most common discount is an interest rate reduction for borrowers who repay their loans through auto-debit, which automatically deducts the monthly loan payments from the borrower’s checking or savings account. Some lenders of private student loans offer auto-debit discounts that reduce the interest rate by 0.25% or 0.50%.