On Wednesday the Fed raised short-term interest rates by 0.25%, with additional rate hikes expected over the course of the year. What does this mean for student loans? Several things.
First, federal student loans have fixed interest rates; those rates are fixed at the time of loan origination. So this will have no impact on federal student (or parent PLUS) loans that have already been issued.
One should assume that for all federal loans other than Perkins Loans (which always have a 5% interest rate), rates will go up. The interest rate on undergraduate direct student loans is the 10 year Treasury yield plus 2.05%– a different number than the Fed sets but generally influenced by it nonetheless. (Graduate and parent PLUS loans have different rates.) The interest rate is fixed for all loan disbursements during a one-year period from July 1-June 30, i.e. for a school year. Next year’s interest rate will be determined by a Treasury auction prior to July 1; one should assume it will be higher.
As long as you stay within the federal loan program, your interest rate won’t change. But there’s a potentially unforeseen issue with rising interest rates beyond just the higher monthly payment: Income-based payment plans.
In an income-based payment plan such as IBR or REPAYE, you pay a fixed monthly amount based on your income. When you make a loan payment, you are paying interest first, then principal. In the early years of repayment, the interest portion is higher and decreases over time. That’s because interest accrues based on the outstanding loan balance. A larger balance means more interest accruing.
Let’s say you owed $50,000 in student loans, with an interest rate of 4.5%. On a 20-year payment term, you’d pay $316 monthly. The first month’s payment would include $187.50 in interest. At the end of the first year, you would have paid $2218 in interest; your loan balance would be $48,422. Bump that interest rate up to 4.75% and the monthly payment increases by $7 overall, with $198 of the $323 payment being interest.
If you were enrolled in an income-based plan and your payment were capped at $190 monthly, then at the lower interest rate, you’d be paying some principal off each month and eventually your loan balance would start to shrink—albeit by very small amounts. At the higher interest rate, however, you would only be paying interest, so your balance would stay the same and at some point in the future, the unpaid interest would be capitalized (added to the loan balance). In many cases, this will happen at the point of loan forgiveness, when the forgiven balance becomes taxable to the borrower. If you made the same payment for the duration of the repayment period (which is unlikely but makes for a simpler illustration), at the point of loan forgiveness you’d owe not just the $50,000 you originally borrowed but also $8 x 12 annual payments x 20 years = $1,920. This is admittedly a gross oversimplification, but you can see how even a small change in the interest rate can have a substantial impact on a borrower over the long term.