There is a lot in the news lately about a possible Fed rate hike. Extremists talk about market turmoil, changes to lending and borrowing, and a new recession. But how much of that is really true, and how does it impact you and your current student loans?
To fully understand what a rate hike means to student loan borrowers, we first must look at what “The Fed” is, how it works, and how its decisions impact the economy.
Whether you are a long time borrower or expect your first student loans in the coming years, read on to learn how a Fed interest rate hike affects you.
What is “The Fed” and why can they choose rates?
When the media refers to The Fed, they are referring to the United States Federal Reserve System. The Federal Reserve System is made up of twelve banks, each assigned to its own region.
At the top of the Federal Reserve is a seven-member Board of Governors, nominated by the President of the United States and confirmed by Congress for a 14-year term. The leader of the Board of Governors is the Chair, currently Janet Yellen.
The United States Federal Reserve System works similarly to central banks in many other countries, with a goal of managing economic growth, inflation, and other economic factors through monetary policy.
The Federal Reserve can control the supply of money and sets important federal funds rate that makes headlines whenever it changes (or analysts think it may change in the near future).
What is the federal funds rate?
The federal funds rate is a key tool that the Federal Reserve can use to help control inflation and economic growth. If interest rates are high, Americans and businesses operating here are encouraged to save and invest. If rates are low, people are encouraged to borrow and spend.
Theoretically, this means that by lowering the interest rate, the Federal Reserve can spark economic growth, and by increasing rates, they can keep inflation from rising too quickly.
The federal funds rate does not directly affect student loans. It’s the rate that banks use to lend to each other overnight.
If Bank #1 needs a few billion dollars for interest payments tomorrow and Bank #2 has an extra few billion dollars in cash, they can lend the funds to Bank #1 and charge the rate set by the Fed for interest.
A Fed funds rate hike means that the interest rate banks charge each other will go up. While that doesn’t affect most other loans directly, there are some important ways it does impact existing loans.
How the Fed rate hike impacts existing loans
Fed interest rates impact what banks charge each other, and based on that, banks decide what to charge businesses and consumers who borrow. The current Fed funds target rate ranges from 0.25% and 0.5%, but you would be hard pressed to find a loan in that range as a consumer.
Banks lend to each other, and then to businesses and consumers. They want to earn a profit when they lend, so they add a margin based on the risk and desired profitability from lending.
By the time you borrow as a consumer, there is a bit of padding added in between you and the Fed funds rate. Only the most creditworthy borrowers can get rates near the Fed funds rate. Those borrowers are the federal government and a few rare, stable companies.
For existing private and federal student loans with a fixed interest rate, interest rates will not budge. That is the big benefit of fixed-rate loans — if interest rates rise, your rate is locked. Most lenders that offer both fixed-rate and variable-rate loans charge a slightly higher interest rate on fixed-rate loans for this reason.
For variable-rate student loans, you can expect to see a change. Some variable rate loans have a defined interest rate at the Fed funds rate plus a margin. In those cases, as soon as the Fed changes its rates, borrowers can expect their rates to increase by the same amount.
For many loans, however, the Fed funds rate isn’t the most important signifier. Some banks use LIBOR, the London Interbank Offered Rate, to determine interest rates. Others still use various economic indicators and factors to determine their rate.
If your variable-rate loan interest rate does increase, it will do so gradually. If you are unsure how your loan works, check out your loan paperwork or call your servicer for more information.
How the Fed rate hike impacts new loans
Fed interest rates will most likely have an impact on future loans, but the impact is still to be determined. Both private lenders and the federal government have to look at economic conditions as a whole before they set rates in the future.
Private banks typically choose rates based on LIBOR. Congress is responsible for setting rates on federal student loans. Odds are, if there is a Fed interest rate hike, other loans’ rates will increase as well — but only time will tell for sure.
What can you do now?
For now, fixed-rate student loan borrowers are best off doing nothing. The same does not apply to variable-rate student loan borrowers, who may be able to refinance at a lower fixed rate and secure a low interest rate.
Student loan borrowers should expect a letter or a noted increase on your next statement if your interest rate will change. Otherwise, just keep on doing what you’re doing and try to get out of debt as soon as you can.
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