Any borrower who has taken out a loan with a bank or a lender has probably spent time wondering how on earth loan companies could afford to part with such a large chunk of change.
If you’re like me, you might imagine that your loan officer goes into an underground vault to bag some cash for your loan, leaving the pile of money a little smaller afterward.
Thankfully for our economy, the reality is that lenders of student loans, mortgages and other debt rely on money to make money. It’s just not as simple as a basement full of cash.
Here’s a breakdown of how loan companies — from banks, online lenders and credit unions to quasi-state-run loan authorities — can lend to borrowers and still turn a profit.
How do loan companies work?
While your loan company doesn’t have a physical pile of cash, there does need to be an influx of money before it can start offering loans. That money comes either from depositors or investors. For instance, when your paycheck is direct deposited to your bank, that money becomes part of the capital that the bank uses to make loans.
Bank depositors will receive much lower interest rates than investors because they reserve the right to withdraw their full balance on demand. An investor, on the other hand, yields access to their money for a certain term — as in the case of a certificate of deposit — in exchange for a higher rate of return.
Let’s say an investor named Harry comes to the bank and deposits $10,000 in his savings account. The following day, a student named Sarah takes a $9,000 student loan from the same bank.
By lending out the $9,000, the bank has almost doubled the money in the economy, since Harry’s $10,000 is available to him and earning interest, while Sarah’s loan is purchasing her $9,000 worth of education.
How loan companies determine interest rates
If banks and loan companies are in the business of making as much money as possible, why don’t all depositors and investors receive minuscule interest rates or none at all? And why don’t all borrowers pay sky-high rates?
Even though a bank is free to set its rates, it also has to take several other factors into account.
1. Federal Reserve monetary policies
The Federal Reserve influences interest rates in a variety of ways, including setting a target for the federal funds rate (the interest rate banks use for borrowing money parked in a Federal Reserve account for one day). The Fed uses market operations to nudge this important interest rate to its targeted level.
The federal funds rate sets something of a floor for rates, since banks generally won’t lend money if they can get a higher rate in the federal funds market. It also indirectly helps banks set their prime rate, which is what the bank would charge the ideal, creditworthy customer for a loan.
As with most private businesses, prices are set with an eye to what the competition is doing. By closely watching the market for financial products, banks and other lenders determine what rates will attract customers.
Naturally, if a lender has the highest rates in town, almost no one will want to borrow from them. And if a bank can afford to offer loan rates below those of its rivals, it can likely steal some business away.
3. Inflation and market volatility
Banks must look at the cost of inflation and potential market volatility over the life of a loan, particularly for long-term loans. The interest rate charged to a borrower has to take into account how much inflation might eat into the bank’s profits.
To protect themselves (and give borrowers more options), some loan companies offer variable interest rates that can often start lower than fixed rates but might then rise over time. With variable interest rates, the bank passes the risk onto the borrower — if rates rise across the financial system, for instance, the bank won’t lose money by being locked into an earlier, lower rate.
So… how do lenders make money?
You’ve probably noticed that banking customers are paid less interest for their savings than borrowers pay out for their debt. From the example above, Harry might receive 2.25% annual percentage yield (APY) on his $10,000 in savings, but Sarah might have to pay at least 5.00% annual percentage rate (APR) on her $9,000 student loan.
That difference between APR and APY, known as the net interest margin, is where lenders make their money.
To put a finer point on it: Banks profit from the difference between what they earn in interest from borrowers and what they owe in interest to depositors and investors.
When a borrower fails to repay their debt, the lender could profit even more. A delinquent student loan, for example, accrues and capitalizes interest, making for an exorbitant repayment for the borrower. On the other hand, a loan in default that’s never repaid could ultimately cost the lender the profit it was expecting.
Don’t forget the fees
Of course, the net interest margin is not the only way that banks and loan companies make money. Fees can also be a source of profit — a fact which consumers should always keep in mind.
In particular, you are likely to see the following types of fees among loan companies:
When a borrower applies for a loan, they will often be faced with an application fee or loan origination fee. Sometimes you will pay this out of pocket, and sometimes the fee will be included with the principal of your loan, which means you will also be paying interest on it.
These fees are generally on the depositor and investor side: You might pay an account fee for a checking account or an investment account as a maintenance charge, though of course there are also fees on the borrower side, as with credit cards.
Using an ATM under another bank’s name will cost you. Often, you’ll pay a fee to the bank that owns the ATM, as well as a fee to your bank.
These fees generally occur when you do things like overdraw your account or make a late payment on a loan. Some student loan companies even penalize borrowers for repaying their loans early — also known as a prepayment penalty.
What about loan companies that don’t act as a bank?
Some lenders make money on a combination of loan origination (fees) and loan repayment (interest). There are newer fintech companies that have also found a third way to turn a profit: repackaging and selling loans made to especially creditworthy borrowers.
In these cases, student loan refinance companies sell off pools of prime loans — collections of debt lent to creditworthy or “prime” borrowers. Investment fund and asset managers purchase the debt because of its appealing cash flow prospects.
SoFi, for example, began earning dividends from securitizations and whole loan sales well before it started resembling a traditional bank, offering investment accounts to its members.
In the end, who profits from student loans?
Let’s return to the bank-borrowing story of Harry and Sarah. Thanks to the fees and, in Sarah’s case, the interest they shell out, the loan company is first to profit. On the student loan front, Sarah also benefits because she receives the money she needs for her education.
That scenario is relatively cut and dry, but in the world of student loan refinancing, on the other hand, the question of who profits is more nuanced.
Let’s say Sarah refinances her $9,000 loan with a competing lender to reduce her interest rate. In this case, she profits by having to pay out less interest in repayment.
In addition, Sarah’s new lender profits from having a creditworthy customer who’s a good bet to make payments, adding to the company’s bottom line. (That explains why refinance companies compete for the most creditworthy borrowers, routinely innovating products and perks.)
When the lending process works the way it should, everyone profits in a sense, even if not to the same degree. After all, the lender could keep profiting in a third way: selling the loan to an investor.
Even though some of these practices might seem magical, it’s critical for all consumers — both borrowers and depositors — to understand the simple ways that loan companies make their money.
Armed with this knowledge, you can at least recognize and avoid unnecessary fees, plus reduce your interest payments. Loan companies have enough cash in their vault as it is.
Andrew Pentis contributed to this report.
Interested in refinancing student loans?Here are the top 9 lenders of 2022!
|Lender||Variable APR||Eligible Degrees|
|2.49% – 11.72%1||Undergrad & Graduate|
|2.50% – 6.30%2||Undergrad & Graduate|
|4.13% – 7.39%3||Undergrad & Graduate|
|2.49% – 7.99%4||Undergrad & Graduate|
|2.49% – 7.99%5||Undergrad & Graduate|
|3.24% – 8.24%6||Undergrad & Graduate|
|2.48% – 7.24%||Undergrad |
|1.74% – 7.99%7||Undergrad & Graduate|
|3.69% – 9.92%8||Undergrad & Graduate|
|Check out the testimonials and our in-depth reviews!
1 Important Disclosures for Splash Financial.
Splash Financial Disclosures
Terms and Conditions apply. Splash reserves the right to modify or discontinue products and benefits at any time without notice. Rates and terms are also subject to change at any time without notice. Offers are subject to credit approval. To qualify, a borrower must be a U.S. citizen or permanent resident in an eligible state and meet applicable underwriting requirements. Not all borrowers receive the lowest rate. Lowest rates are reserved for the highest qualified borrowers. If approved, your actual rate will be within a range of rates and will depend on a variety of factors, including term of loan, a responsible financial history, income and other factors. Refinancing or consolidating private and federal student loans may not be the right decision for everyone. Federal loans carry special benefits not available for loans made through Splash Financial, for example, public service loan forgiveness and economic hardship programs, fee waivers and rebates on the principal, which may not be accessible to you after you refinance. The rates displayed may include a 0.25% autopay discount. Fixed loans feature repayment terms of 5 to 20 years. For example, the monthly payment for a sample $10,000 with an APR of 5.47% for a 12-year term would be $94.86. Variable loans feature repayment terms of 5 to 25 years. For example, the monthly payment for a sample $10,000 with an APR of 5.90% for a 15-year term would be $83.85.
The information you provide to us is an inquiry to determine whether we or our lenders can make a loan offer that meets your needs. If we or any of our lending partners has an available loan offer for you, you will be invited to submit a loan application to the lender for its review. We do not guarantee that you will receive any loan offers or that your loan application will be approved. Offers are subject to credit approval and are available only to U.S. citizens or permanent residents who meet applicable underwriting requirements. Not all borrowers will receive the lowest rates, which are available to the most qualified borrowers. Participating lenders, rates and terms are subject to change at any time without notice.
To check the rates and terms you qualify for, Splash Financial conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, the lender will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.
Splash Financial and our lending partners reserve the right to modify or discontinue products and benefits at any time without notice. To qualify, a borrower must be a U.S. citizen and meet our lending partner’s underwriting requirements. Lowest rates are reserved for the highest qualified borrowers. This information is current as of September 6, 2022.
2 Important Disclosures for Laurel Road.
Laurel Road Disclosures
All credit products are subject to credit approval.
Laurel Road began originating student loans in 2013 and has since helped thousands of professionals with undergraduate and postgraduate degrees consolidate and refinance more than $9 billion in federal and private school loans. Laurel Road also offers a suite of online graduate school loan products and personal loans that help simplify lending through customized technology and personalized service. In April 2019, Laurel Road was acquired by KeyBank, one of the nation’s largest bank-based financial services companies. Laurel Road is a brand of KeyBank National Association offering online lending products in all 50 U.S. states, Washington, D.C., and Puerto Rico. All loans are provided by KeyBank National Association, a nationally chartered bank. Member FDIC. For more information, visit www.laurelroad.com.
As used throughout these Terms & Conditions, the term “Lender” refers to KeyBank National Association and its affiliates, agents, guaranty insurers, investors, assigns, and successors in interest.
Assumptions: Repayment examples above assume a loan amount of $10,000 with repayment beginning immediately following disbursement. Repayment examples do not include the 0.25% AutoPay Discount.
Annual Percentage Rate (“APR”): This term represents the actual cost of financing to the borrower over the life of the loan expressed as a yearly rate.
Interest Rate: A simple annual rate that is applied to an unpaid balance.
Variable Rates: The current index for variable rate loans is derived from the 30-day Average Secured Overnight Financing Rate (“SOFR”) and changes in the SOFR index may cause your monthly payment to increase. Borrowers who take out a term of 5, 7, or 10 years will have a maximum interest rate of 9%, those who take out a 15 or 20-year variable loan will have a maximum interest rate of 10%. There is no limit on the amount your interest rate can increase at one time. The Index is currently published by the Federal Reserve Bank of New York (“New York Fed”). If the Index is no longer available, it will be replaced by a replacement Index according to the terms of the promissory note.
KEYBANK NATIONAL ASSOCIATION RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE.
This information is current as of April 29, 2021. Information and rates are subject to change without notice.
3 Important Disclosures for LendKey.
Refinancing via LendKey.com is only available for applicants with qualified private education loans from an eligible institution. Loans that were used for exam preparation classes, including, but not limited to, loans for LSAT, MCAT, GMAT, and GRE preparation, are not eligible for refinancing with a lender via LendKey.com. If you currently have any of these exam preparation loans, you should not include them in an application to refinance your student loans on this website. Applicants must be either U.S. citizens or Permanent Residents in an eligible state to qualify for a loan. Certain membership requirements (including the opening of a share account and any applicable association fees in connection with membership) may apply in the event that an applicant wishes to accept a loan offer from a credit union lender. Lenders participating on LendKey.com reserve the right to modify or discontinue the products, terms, and benefits offered on this website at any time without notice. LendKey Technologies, Inc. is not affiliated with, nor does it endorse, any educational institution.
Subject to floor rate and may require the automatic payments be made from a checking or savings account with the lender. The rate reduction will be removed and the rate will be increased by 0.25% upon any cancellation or failed collection attempt of the automatic payment and will be suspended during any period of deferment or forbearance. As a result, during the forbearance or suspension period, and/or if the automatic payment is canceled, any increase will take the form of higher payments. The lowest advertised variable APR is only available for loan terms of 5 years and is reserved for applicants with FICO scores of at least 810.
As of 09/09/2022 student loan refinancing rates range from 4.13% APR – 7.39% Variable APR with AutoPay and 2.99% APR – 9.93% Fixed APR with AutoPay.
4 Rate range above includes optional 0.25% Auto Pay discount. Important Disclosures for Earnest.
You can choose between fixed and variable rates. Fixed interest rates are 3.99% – 8.74% APR (3.74% – 8.49% APR with Auto Pay discount). Starting variable interest rates are 2.74% APR to 8.24% APR (2.49% – 7.99% APR with Auto Pay discount). Variable rates are based on an index, the 30-day Average Secured Overnight Financing Rate (SOFR) plus a margin. Variable rates are reset monthly based on the fluctuation of the index. We do not currently offer variable rate loans in AK, CO, CT, HI, IL, KY, MA, MN, MS, NH, OH, OK, SC, TN, TX, and VA.
5 Important Disclosures for Navient.
6 Important Disclosures for SoFi.
Fixed rates range from 3.99% APR to 8.24% APR with a 0.25% autopay discount. Variable rates from 3.24% APR to 8.24% APR with a 0.25% autopay discount. Unless required to be lower to comply with applicable law, Variable Interest rates on 5-, 7-, and 10-year terms are capped at 8.95% APR; 15- and 20-year terms are capped at 9.95% APR. Your actual rate will be within the range of rates listed above and will depend on the term you select, evaluation of your creditworthiness, income, presence of a co-signer and a variety of other factors. Lowest rates reserved for the most creditworthy borrowers. For the SoFi variable-rate product, the variable interest rate for a given month is derived by adding a margin to the 30-day average SOFR index, published two business days preceding such calendar month, rounded up to the nearest one hundredth of one percent (0.01% or 0.0001). APRs for variable-rate loans may increase after origination if the SOFR index increases. The SoFi 0.25% autopay interest rate reduction requires you to agree to make monthly principal and interest payments by an automatic monthly deduction from a savings or checking account. This benefit will discontinue and be lost for periods in which you do not pay by automatic deduction from a savings or checking account. The benefit lowers your interest rate but does not change the amount of your monthly payment. This benefit is suspended during periods of deferment and forbearance. Autopay is not required to receive a loan from SoFi.
7 Important Disclosures for Purefy.
Purefy Student Loan Refinancing Rate and Terms Disclosure: Annual Percentage Rates (APR) ranges and examples are based on information provided to Purefy by lenders participating in Purefy’s rate comparison platform. For student loan refinancing, the participating lenders offer fixed rates ranging from 2.73% – 7.99% APR, and variable rates ranging from 1.74% – 7.99% APR. The maximum variable rate is 25.00%. Your interest rate will be based on the lender’s requirements. In most cases, lenders determine the interest rates based on your credit score, degree type and other credit and financial criteria. Only borrowers with excellent credit and meeting other lender criteria will qualify for the lowest rate available. Rates and terms are subject to change at any time without notice. Terms and conditions apply.
8 Important Disclosures for Citizens.
Education Refinance Loan Rate Disclosure: Variable interest rates range from 3.69%-9.92% (3.69%-9.92% APR). Fixed interest rates range from 4.49%-10.11% (4.49%-10.11% APR).
Undergraduate Rate Disclosure: Variable interest rates range from 6.39%- 9.60% (6.39% – 9.60% APR). Fixed interest rates range from 6.58% – 9.79% (6.58% – 9.79% APR).
Graduate Rate Disclosure: Variable interest rates range from 3.69% – 9.16% (3.69% – 9.16% APR). Fixed interest rates range from 4.49% – 9.35% (4.49% – 9.35% APR).
Education Refinance Loan for Parents Rate Disclosure: Variable interest rates range from 3.69%- 9.09% (3.69%- 9.09% APR). Fixed interest rates range from 4.49% – 9.28% (4.49% – 9.28% APR).
Medical Residency Refinance Loan Rate Disclosure: Variable interest rates range from 3.69% – 9.16% (3.69% – 9.16% APR). Fixed interest rates range from 4.49% – 9.35% (4.49% – 9.35% APR).