Interest Rates Are Down, Time to Get a Private Student Loan?

If you are a follower of the financial aid and student loan industry, you have seen that there has been a recent upheaval in regards to how federal student loans are distributed and increased downward pressure on interest rates. In addition, a planned interest rate reduction for federal subsidized Stafford loans goes into effect in July 2010, from 5.6% to 4.5%. In July 2011, there will be another planned rate cut to 3.4%.

Thanks to the Student Aid and Fiscal Responsibility Act (SAFRA) passed into law in March, private banks will no longer be allowed to originate federal student loans for students attending schools that are affiliated with the Federal Family Education Loan (FFEL) Program. The effect of this new bill is that as of July, the banks participating in FFEL will be losing a substantial revenue stream and will start to look elsewhere to recoup the lost income. Due in part to these changes, banks are lowering their interest rates and fees to attract borrowers that ordinarily may not be as keen to apply for a credit-based loan. You may be wondering, “What does that mean for me?” Two main things:

  1. Lower interest rates = less money paid over the life of the loan
  2. Historically low index rate = potential to pay more over the life of the loan

Sounds counter-intuitive, right? Let’s break down the terms and uncover the hidden meanings.

Interest Rate: the percentage of a sum of money charged for its use; this number is usually derived from a variable index rate plus a “margin.”

E.g. If you lent me $100 for a year at 5% interest, when I pay you back… the total will be $105. That $5 is what you charge me to borrow the money.

Index: A statistical indicator that measures changes in the economy in general or in particular areas. In the case of student loans, the federal funds rate and London Interbank Offered Rate (LIBOR*) are typically the most commonly used indices (The Free Financial Online Dictionary).

*If you want to learn more about LIBOR and the federal funds rate, they are published daily in the Wall Street Journal and are available online from a wide variety of financial websites.

These indices change over time depending on how the economy is performing. If the economy is great, they tend to be higher; if it is doing badly — or in our case, recovering from an intense global recession — they tend to be lower. These changes are all methods of financial controls to help expand or slow down the economy. If you do not have a background in economics, the important thing to remember is that the Fed does not want our economy to grow or shrink too fast; stable, gradual growth is always preferred over rapid growth because it constitutes lower financial risk and is easier to forecast. Now that you know what these terms mean, I invite you to think about how a historically low index rate might affect your student loan. To get a firm grasp, there are a few key points you need to keep in mind:

  1. All private student loans have variable interest rates (meaning they change); generally the rates are re-adjusted every 3-6 months
  2. Low index rates = recession economy or an economy that is set for high growth
  3. Interest rates are at least partially based on index rates

When you connect the dots, you see that there is a distinct possibility that as the economy improves, so will the indices. The result? Your variable interest rate will rise along with the index and cost more money in the long run. Sounds kind of negative, right? Not necessarily. Due to these historically low index rates, you can actually get a private student loan (assuming you have a good or excellent credit score, or creditworthy co-signer) at interest rates lower than a federal Parent PLUS loan. The game here is really finding a loan that has the best of all worlds. In this case, you want to find one that has a low “margin” number. You know when you see a loan offer and it says something like LIBOR + 3% or Prime + 2.5%? That “+X%” is a margin.

Thus your objective, daring loan seeker, is to find a private loan that has both a low margin and low to medium index rate. The more stable the index is, the more stable your interest rate will be. Keep in mind that you are under no obligation to accept the first loan offer you receive and have a 30-day window to apply for loans without taking a credit penalty. As a responsible borrower, you are encouraged to shop around for loans and find a product that matches both your needs and financial capability.