Student Loans: Government Interest Charges Explained

Student loan interest rates vary depending on the type of loan and the lender. Federal student loans have fixed interest rates for the life of the loan, while private student loans typically offer variable interest rates. For subsidized federal student loans, the US government pays the interest while the borrower is in school. In contrast, interest on other federal loans and private loans generally accrues while the borrower is still in school. Private loans usually originate from banks, credit unions, or schools, and their interest rates are based on the borrower's credit score. Congress sets federal student loan interest rates yearly based on the 10-year Treasury note.

Federal student loans have fixed interest rates

Federal student loans do charge interest, but they also come with benefits that private loans do not offer. For example, federal loans offer flexible repayment plans based on income, borrower protections, loan forgiveness programs, and payment pauses. Additionally, students with financial needs may qualify for subsidized loans, which means the government pays the interest that accrues while the student is still in school.

The interest rates for federal student loans are typically set once a year based on an economic benchmark. Congress determines new student loan rates each spring, and these rates apply to loans disbursed from July 1 to June 30 of the following year. The rates are not based on creditworthiness, but rather on economic factors and the type of loan.

It is worth noting that federal student loan rates tend to be slightly higher than the lowest private student loan rates. However, as mentioned earlier, federal loans come with built-in forbearance options and income-driven repayment plans, making them a more stable and flexible option for borrowers. The choice between a federal or private student loan depends on various factors, including credit score, income, and the overall cost of the loan, including interest.

Private student loans have variable interest rates

Federal student loans have fixed interest rates, while private student loans offer both fixed and variable rates. Variable interest rates on private student loans can be risky as they fluctuate according to market conditions. If inflation goes up, so does your interest rate, which can make your loan more expensive. Variable rates are subject to change monthly, quarterly, or annually.

Private student loan interest rates are influenced by the borrower's credit score, income, and loan term. A higher credit score will generally qualify borrowers for lower interest rates, while a lower credit score will result in higher rates. Private student loan lenders offer variable rates ranging from 4.13% to 18.51%. Variable rates can be a gamble since future market conditions are unpredictable.

However, variable rates on private student loans usually offer lower starting interest rates than fixed-rate loans. If inflation decreases over time, borrowers with a variable-rate loan will benefit from a lower interest rate than those with a fixed rate. Additionally, borrowers who feel that interest rates will decrease over the life of their loan may prefer variable rates.

It is important to note that private student loans are more difficult to qualify for due to lenders' strict requirements. Federal student loans should always be applied for first as they have lower fixed-interest rates and offer benefits that private student loans do not, such as borrower protection and repayment plans.

The US government pays interest for subsidised federal student loans

In the United States, the federal government pays interest for subsidised federal student loans. This means that during the repayment pause that began in March 2020 and ended on September 1, 2023, loan balances did not accumulate interest. Consequently, borrowers are not charged retroactive interest as their payments become due. This measure was implemented to provide financial relief for borrowers, especially those on income-driven repayment plans who may struggle to cover the monthly interest on their loans.

It is important to note that student loan servicers are private companies or organisations that bill and collect the principal and interest from borrowers on behalf of the government. While borrowers owe money to the federal government, the loan servicers are paid a flat monthly fee per loan by the government. This fee structure incentivises servicers to assist borrowers who have fallen behind on their payments to get back on track.

The concept of the government paying interest on subsidised federal student loans is in contrast to the general expectation that individuals should bear the cost of their college education. Elizabeth Tandy Shermer, a history professor at Loyola, noted that Congress has typically favoured charging interest on student loans, reflecting the belief that it is "un-American" to provide financial assistance without expecting repayment.

Despite the government's efforts to alleviate interest burdens during the repayment pause, it is still common for interest to accumulate on student loans over time. This can occur when reduced monthly payments under income-driven repayment plans are insufficient to cover the monthly interest, resulting in unpaid interest being added to the loan balance. As a result, borrowers may end up owing more than their original debt. Therefore, while the government does not charge interest on subsidised federal student loans during specific periods, the overall student loan system in the US is characterised by interest accumulation.

Interest accrues for most other loans

In Canada, students are campaigning for the federal government to stop charging interest on student loans. This is because the cost of attending post-secondary school is already very high, and students routinely have to take out loans to pay for it. The Canadian government is set to make $862.2 million in revenue from interest on student loans this year, a number that has been rising year on year.

In the US, the situation is slightly different. For subsidized federal student loans, the US government pays the interest while the student is in school. However, interest accrues for most other loans. This means that students will owe more than they borrowed by the time they leave school. Interest accrued while studying can be "capitalized", meaning it is added to the loan's unpaid principal balance. When capitalization occurs, students are charged interest on interest. For example, if a student borrows $5,000 at a 10% annual rate for a 12-month program, they will accrue $500 in interest while in school and $250 during the six-month grace period, for a total of $750 in accrued interest by the end of the grace period. Capitalization adds this $750 to the principal balance, resulting in a total of $5,750. Interest will then continue to accrue from this new balance.

Private student loan interest rates can sometimes be lower than federal rates, but approval for the lowest rates requires excellent credit (scores above 689). Private loans are typically used to fill funding gaps after maxing out federal loans.

Private student loans depend on credit scores and income

Federal student loans are based on financial need and enrollment status, and do not have strict credit score requirements. However, private student loans often require a credit score of at least 670. Lenders will review an applicant's credit score and history to assess how well they have managed money in the past. A good credit score indicates that the applicant has successfully managed debt and is likely to repay their loan. Therefore, a higher credit score generally leads to better approval odds and the chance of qualifying for a lower rate.

A higher credit score can also result in more favorable loan terms. For example, a higher score may allow for a longer repayment term, reducing the monthly payment amount. On the other hand, a low credit score can make it more difficult to qualify without a cosigner. Even if an applicant with a low credit score is able to qualify on their own, they will likely be charged a higher interest rate and fees to compensate for the higher probability of defaulting on the loan.

In addition to credit scores, private lenders may also consider an applicant's income when making lending decisions. Some lenders may offer secured loans, where the borrower provides collateral such as a savings account or real estate to secure the loan. This can be a good option for students with low or no credit.

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