How Are My Student Loan Interest Rates Decided?

student loan interest rates

Anyone who borrows money to pay for college will have to pay interest according to current student loan rates. And for recent graduates breaking into the job market, these rates can be painful.

But while you may know how student loan interest rates work in general, you might be wondering how your particular rate gets set by your lender or servicer.

The answer depends on whether you have federal student loans or private student loans. Here’s what you need to know about how student loan rates are decided and how today’s rates compare to previous years.

How are student loan interest rates set?

The Department of Education adjusts federal student loan interest rates for each school year. These rates apply to all students regardless of credit history.

Private lenders, on the other hand, set rates based on the creditworthiness of each individual applicant. They consider factors such as credit credit score, job history, and income.

Although trends in the stock market and economy also affect both private and federal student loan rates, they do so in different ways. Find out more about these differences below.

Who sets the formulas for federal student loan rates?

All federal student loan rates are set by Congress, according to the Federal Student Aid Office.

Congress passes into law the interest rates set by the Department of Education each year. The rates they pass are based on 10-year Treasury notes, plus a fixed increase.

Student loan rates are set in the spring for each new school year. They are effective from July 1 to June 30 of the following year. To ensure interest rates don’t get too high, Congress also includes student loan rate caps for each type of loan.

Here’s the formula used for different types of loans, per the Congressional Budget Office (CBO):

  • Direct undergraduate loans: 10-year Treasury + 2.05%, capped at 8.25%
  • Direct graduate loans: 10-year Treasury + 3.60%, capped at 9.50%
  • Direct PLUS loans: 10-year Treasury + 4.60%, capped at 10.50%

Based on the above formula, undergraduate students pay the least to borrow for college. Parents and graduate students will usually pay more to finance educational costs.

Lastly, federal student loan rates apply equally to borrowers on all loans disbursed in the relevant year.

The Department of Education approves borrowers for federal student loans based on need. To qualify, you need to apply using the Free Application for Federal Student Aid (FAFSA). Factors such as a student’s or family’s income will affect how much aid they receive. However, these factors have no effect on federal student loan rates.

How do lenders set private student loan rates?

To get a private student loan, you will apply directly with the student loan lender.

Each private lender has its own underwriting process and standards for student loan applicants; these eligibility requirements help lenders decide whether to give an applicant a loan and at what interest rate.

To qualify for a private student loan, you need to meet these underwriting standards (or have a cosigner who does). Common eligibility requirements for approval consider your credit score, credit history, and income. The lender might also consider factors such as educational attainment or career history or field.

Unlike federal student loans that offer universal rates, private lenders use their own lending models to set and offer individualized rates for each borrower. Here are the three main factors that affect the rates lenders offer on private student loans.

1. Your credit score

For most lenders, a lot of focus is put on your credit score. Luckily, that’s also the part of the interest rate equation you can control the most.

Lenders use your credit score and history to set private student loan interest rates. Typically, the better your credit, the more likely a lender is willing to finance a loan at a lower rate. That’s because you’ve shown you’re capable of repaying your debts and pose a lower risk.

To qualify for a private student loan, you’ll usually need a credit score of 660-680 or higher. Borrowers will get better interest rates with good credit scores of 700 or higher, and get the best rates with excellent credit scores of 750 or more.

To maintain a good credit score, make sure you:

  • Stay current on your debt payments, making full and timely payments each month. Payment history is the single biggest factor in determining your credit.
  • Keep revolving debt low, such as credit card balances, compared to your credit limit. This is your credit utilization ratio. Keeping it low (under 30 percent) is a key ingredient to a good score.
  • Maintain older accounts, as these contribute to the length of your credit history, which lenders like to see. And don’t be afraid to try out different types of credit products; this can add to your credit mix, too.

2. Your student loan terms

The terms you choose on your private student loans will also influence the interest rates you’re offered.

For instance, lenders commonly offer variable interest rates on student loans. Choosing these will often get you a lower introductory rate than a fixed-rate loan. You will also usually get a lower student loan interest rate if you choose a shorter repayment period.

3. Market trends

Private student loan interest rates are also typically based on a more general interest benchmark — similar to how federal student loan rates are tied to 10-year Treasury bond rates.

Student lenders most commonly set rates according to the LIBOR (London Interbank Offered Rate) or the prime rate. These are averaged, index rates that reflect larger economic forces and market prices.

What are current student loan rates?

Federal student loan rates are fairly low for the 2016-17 school year compared to the past 10 years — but they are on the rise:

  • 2016-17 Direct undergraduate loans: 3.76%
  • 2016-17 Direct graduate loans: 5.31%
  • 2016-17 Direct PLUS loans: 6.31%

New federal student loan rates were just announced in May, based on the most recent 10-year Treasury bond rates. Federal student loan rates for 2017-18 all rose 0.69%:

  • 2017-18 Direct undergraduate loans: 4.45%
  • 2017-18 Direct graduate loans: 6.00%
  • 2017-18 Direct PLUS loans: 7.00%

Current student loan rates from private lenders are also fairly low. The best private student loan providers offer rates starting as low as 3.00%. That’s comparable to undergraduate rates on federal student loans.

However, that only reflects the lowest rates these lenders offer. Many borrowers won’t qualify for rates this low. Private student loan rates can reach upwards of 9.00% to 12.00%.

Comparing historical and current student loan rates

Even with the recent bump in federal student loan rates, borrowing remains fairly affordable.

For instance, current student loan rates are 3.80 percentage points lower than the rate caps that mark the highest possible student loan rates. See historic student loan rates over the past decade in the chart below, courtesy of Forbes.

student loan interest rates

Image credit: Forbes

However, the current formulas and caps on federal student loan rates are still fairly new. They were instituted in 2013 with the passing of the Bipartisan Student Loan Certainty Act.

Rates on federal student loans had doubled in 2013, from the 3.40% rate for 2012-13 to 6.80% for 2013-14. Congress responded to outcry over these doubled rates with new rules that capped student loan interest rates and tied them to 10-year Treasury bonds.

That’s why student loan interest rates were typically higher before the Student Loan Certainty Act. It’s also why rates have varied more often year-to-year since.

The current student loan interest rates for 2017-18 are not among historic lows. But they are on par with those charged during the 2014-15 and 2015-16 school years.

Will student loan interest rates continue to rise?

Interest rates are rising — and so will student loan interest rates. How fast student loan rates rise will depend on larger economic and market trends.

As of January 2017, the CBO expects federal loan rates to increase by about 0.25-0.40% each year for the next four years, before leveling out at around 5.50-5.65%.

Of course, these are only projections of future rates, not guaranteed rates.

Plus, the CBO projected an increase of 0.55% for 2017-18, a bit lower than the actual 0.69% increase. However, this can give student loan borrowers an idea of what federal student loans could look like in the next 10 years.

Overall, today’s student loan interest rates are on the lower end, providing student loan borrowers the best deals they might get for years to come.

To take advantage of today’s lower rates, consider taking these steps:

  • Research student loan refinancing to see if you could get a lower rate compared to what you’re already paying. You have a good chance to get a lower offer — for now.
  • Look into private student loans alongside federal student loan offers, especially if you’re a parent or graduate student facing higher interest rates. Today’s private student loan rates often beat those offered on PLUS loans.
  • Work on improving your credit so you can qualify for the best student loan rates.

With rising rates, borrowers need to carefully consider student loan and repayment options. By knowing how student loan rates are determined, you’re better equipped to compare options and make the best choice for your situation.

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