Interest is a fee paid by a borrower to a lender in exchange for the use of the lender’s money. Interest is charged as a percentage of the principal (the amount borrowed), usually on a monthly, quarterly or annual basis. The interest rate may be expressed as an annual percentage rate, even if the interest is charged more frequently. In addition to interest, borrowers may be charged a loan fee upon disbursement of the loan.
Each type of federal student loan has a different interest rate. The current interest rates and fees on federal student loans for @AYCurrent are shown in the table below.
Interest rates on Direct Subsidized and Unsubsidized Loans are currently the same for the subsidized and unsubsidized versions. The interest rate on a federal consolidation loan is based on the interest rates of the federal education loans that are consolidated. Interest rates on private student loans may be based on the credit history of the borrower (and cosigner, if any) and can be either fixed or variable.
In addition, there are two other federal student loans.
Health Professions Student Loans (HPSL) are low-interest fixed-rate loans for undergraduate and graduate students with exceptional financial need. The interest rate is 5.0% fixed. Students must be enrolled full-time in one of the following doctoral programs: Allopathic medicine, Osteopathic medicine, Dentistry, Pharmacy, Podiatric, Optometry or Veterinary medicine. Students are not responsible for paying the interest on the loan during in-school, grace and deferment periods. Borrowers must be U.S. citizens or eligible non-citizens. According to federal regulations, parent income and asset information must be taken into account, regardless of dependency status, when determining eligibility for the HPSL.
Nursing Student Loans (NSL) are low-interest fixed-rate loans for eligible students with exceptional financial need. The interest rate is 5.0% fixed. Funds are available to students with exceptional financial need who attend accredited schools of nursing in the U.S. and its territories and who are in the following nursing training programs: Diploma, Associate, Baccalaureate and Graduate. Students are not responsible for paying the interest on the loan during in-school, grace and deferment periods. Borrowers must be U.S. citizens or eligible non-citizens.
Fixed vs. Variable Interest Rates
Interest rates may be fixed or variable. A fixed interest rate does not change over the life of the loan, although each year’s new loans may have a different fixed interest rate. A variable rate (sometimes called a floating rate) changes periodically, based on changes in prevailing interest rates. Variable interest rates are often expressed as the sum of an index rate, which changes periodically, and a fixed margin. Indexes that have been used with student loans include the 10-year Treasury rate, the 91-day T-Bill rate, the LIBOR index and the Prime Lending Rate.
Impact of the Interest Rate on Loan Payments
The interest rate affects the loan payment because a portion of each payment pays the new interest that has accrued since the previous payment, in addition to repaying part of the principal balance of the loan. Since interest is charged based on the outstanding principal balance of the loan, the portion of each payment devoted to paying interest will decrease as the principal balance decreases. This leads to a phenomenon where borrowers experience quicker progress in repaying the debt when they are further into the repayment term, since more of each payment is applied to the principal balance instead of interest.
Normally, the loan payments will exceed the new interest that has accrued. If the loan payments are less than the new interest, the loan is said to be negatively amortized. Most student loans cannot be negatively amortized, with the exception of the income-contingent, income-based and pay-as-you-earn repayment plans on federal education loans. However, a student loan may be negatively amortized during a deferment or forbearance. There are no prepayment penalties on federal and private student loans, so nothing stops a borrower from paying the new interest as it accrues during a deferment or forbearance period.
If interest is unpaid as it accrues during a deferment or forbearance, it may be capitalized. Capitalization adds the interest to the loan balance, increasing the size of the loan. When the interest is capitalized, the lender will start charging interest on the interest, since it is then part of the principal balance of the loan. This can have a big impact on the cost of the loan.
Federal student loans capitalize the interest once, at the end of the deferment or forbearance period. Private student loans may capitalize the interest more frequently.
The next table shows the increase in the principal loan balance of capitalizing the interest once at repayment, assuming the borrower borrows to the limit for all four years of undergraduate study, with disbursements in September and January and a 6-month grace period before repayment begins. (There is no annual limit on the PLUS Loan, so the table assumes $15,000 borrowed per year. Interest rates were assumed to be the current 2014-2015 interest rates.)
If the interest on the PLUS Loan were capitalized monthly, the loan balance at repayment would be $12,482 (20.8%) higher than the original principal balance. For monthly capitalization of Direct Unsubsidized Loans for a dependent undergraduate student, the loan balance at repayment would be $3,304 (12.2%) higher than the original principal balance.
Subsidized vs. Unsubsidized Interest
Interest on a student loan may be subsidized or unsubsidized. The federal government pays the interest on a subsidized loan while the borrower is enrolled at least half-time and during other periods of authorized deferment. This effectively reduces the interest rate to 0.0% during the in-school period. Examples of subsidized federal student loans include the Perkins Loan and the Direct Subsidized Loan.
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. The auto-debit discount on federal direct education loans is a 0.25% reduction in the interest rate. Some lenders of private student loans offer auto-debit discounts that reduce the interest rate by 0.25% or 0.50%.
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.
Impact of Interest Rates vs. Fees
Loan disbursement and default fees are effectively a form of up-front interest. Assuming a 10-year repayment term, a 4% fee is the equivalent of an increase in the interest rate of about seven-eighths to one percentage point. Assuming a 30-year repayment term, a 4% fee is the equivalent of an increase in the interest rate of about one-third to half a percentage point. The relative impact of a fee is greater with a shorter repayment term or if the borrower prepays the loan, since the fee will be amortized over less time. This is why borrowers who plan to pay off a loan early may wish to avoid up-front fees, if possible.
Impact of Changes in Interest Rates on Loan Payments
Increasing the interest rate on a student loan will increase the monthly payments by about 5% for a 10-year term, about 9% for a 20-year term and about 12% for a 30-year term. For example, increasing the interest rate on a $10,000 loan with a 10-year repayment term from 5.0% to 6.0% will increase the monthly payment from $106 to $111, a 4.7% increase. On a 30-year term it increases the monthly payment from $53.68 to $59.96, an 11.7% increase. Thus the increase in the interest rate on a variable-rate loan will lead to an increase the loan payments, affecting the affordability of the debt.
Choosing the Lowest Cost Loan
Generally, borrowers who want to minimize the cost of their loans should choose the loan with the lowest no-fee equivalent interest rate first. However, borrowers should also compare loans based on other loan terms, such as the availability of deferments and forbearances, alternate repayment terms and loan forgiveness, cancellation and discharge options. Given the mix of interest rates, terms and other benefits, borrowers should generally choose federal loans first. Federal student loans tend to be cheaper, more available and have better repayment terms.
However, borrowers should recognize that variable interest rates may change, significantly increasing the cost of the loan. So, comparing a fixed rate with a variable rate is not an apples-to-apples comparison. In a rising interest rate environment borrowers could add several percentage points to the interest rate on a variable-rate loan to estimate the interest rate on an equivalent fixed-rate loan.
This table shows the impact of different interest rates on the monthly loan payment for various repayment terms, assuming a $30,000 principal loan balance.