Federal Student Loan Rates Are Going Up. Now What?

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 Derek Jess By: Derek Jess

Interest Rates on Federal Student Loans Are on The Rise. Consider these 5 Key Benefits Before Bypassing Them For Private Student Loans.

On July 1st of each year, the federal government sets interest rates on Direct student loans for the upcoming academic school year. For the 2021-2022 school year, interest rates on new Stafford loan disbursements to undergraduate borrowers will be 3.734%, up from 2.75% the year prior.

With advertisements for private student loans with rates still as low as 1%1, it might be tempting to bypass federal loans altogether to save a few bucks on interest. However, there’s more to the story than advertised interest rates.

Here are 5 important advantages of federal student loans to consider before passing them up for private student loans.

1.  Greater Flexibility of Repayment

One of the most helpful features of federal loans is the flexibility of repayment terms. In addition the standard 10-year repayment plan, there are a number of repayment options available with monthly payments that are calculated based on a percentage of current income.2 The primary aim of this payment structure is to ensure that monthly student loan payments fit comfortably within your child’s monthly budget after college. This is generally not an option with private student loans. Federal loans also allow for a suspension of loan payments due to financial difficulty for up to 3 years.3 Most private student loans don’t offer this option either, and the ones that do typically allow up to just 12 months of deferral.

As an added perk unique to the world we live in today, all federal student loans are currently in forbearance as a result of COVID relief measures with a suspension of required monthly payments and a complete waiver of interest. Since all federal loans currently have an effective interest rate of 0%, any voluntary payments made at this time apply to principal, potentially saving borrowers money on interest over the life of the loan and helping to pay it off sooner. This forbearance applies to federal student loans only and is currently effective through January 31, 2022.

2.  Interest Savings While in School

There are two types of Stafford loans available for undergraduate students – subsidized and unsubsidized. Both loans allow for a suspension of payments while your child is in school, as do most private student loans. Subsidized loans have slightly better terms that are offered to students and families with a demonstrated financial need, the primary benefit being that the U.S. Department of Education pays the interest while your child is in school and during other periods of deferment. Interest is typically not waived while your child is in school with private loans.

Interest does accrue while your child is in school for unsubsidized Stafford loans, but it is added to the loan all at once after your child graduates or is no longer at least a half-time student. Compare this to private student loans where interest is typically added to the loan balance monthly. In this case, interest charged each month is added to the balance of the loan and you are charged interest on that interest, resulting in a higher student loan balance by the time payments begin.

3.  No Cosigners Required

As with most loans and lines of credit, lenders of private student loans require the borrower to demonstrate an ability to repay the loan. The top two factors taken into consideration are an established positive credit history and a stable stream of income to support monthly payments, one or both of which are often unsatisfied by your child alone. As a result, more than 92% of private student loans require a cosigner for approval.4 That means mom or dad are also on the hook for payments being made in full and on time. If not, your credit score and your child’s credit score may suffer, making it more difficult for either one of you to secure funding through loans at affordable rates in the future.

You may think that you’ll be able to take yourself off the loan at some point. While this is sometimes an option, many lenders do not allow this without a full refinance of the loan, and the ones that do still require your child to demonstrate an ability to repay without your credit score and income to support the loan. Don’t get your hopes up that this will be an easy process. The Consumer Financial Protection Bureau found that 90% of requests to remove a cosigner from private student loans are denied.5

None of this hassle exists with federal Stafford loans as a cosigner is not required. The loans are provided regardless of current income and credit history and the student is solely responsible for repayment after graduation.

4.  (Generally) Lower Interest Rates

Interest rates on private student loans are subject to the credit scores of the borrower and cosigner. Unless your credit scores are pristine, your child is unlikely to get the lowest advertised rate. By contrast, interest rates on federal Stafford loans are set each year and fixed for the life of the loan. Everybody gets the same interest rate, regardless of credit history.

In addition, many of the lowest-rate options for private student loans are variable interest rate loans, meaning the interest rate can go up or down based on market conditions. While these types of loans may offer lower rates today, they will get more expensive if interest rates continue to go up in the future. If you and your child decide to go with a variable-rate loan, you’ll want to be sure to ask your lender how often rates change. Typically, it’s between monthly and once per year.

5.  Potential Loan Forgiveness

There is an abundance of opportunity available for potential forgiveness of federal student loans, ranging from Public Service Loan Forgiveness and Teacher Loan Forgiveness, discharge in the event of death and disability, and forgiveness after 20-25 years of repayment on one of the income-based repayment plans. In addition, the current administration and many members of Congress are pushing for some amount of federal student loan forgiveness per borrower.

Some private student loans are discharged at death, but it is much less common in the event of total disability. There is no forgiveness of private student loans after a certain number of years and a partial forgiveness of federal student loans across the board would likely not apply to private student loans.

Federal Stafford loans can be a great way to bridge a funding gap for your child’s undergraduate education. However, with a limitation of $27,000 for most students over the course of a four-year undergraduate degree, Stafford loans are sometimes not enough to cover the entire shortfall, meaning that alternative financing options may be needed. Even after a rate increase of 1%, it generally makes sense to start with federal student loans, tapping into private student loans and other financing vehicles each year as necessary.

Next Steps:

Although there are financing options available to cover pretty much any amount of education expenses, up to the full cost of attendance at any university, your family should be thoughtful about how much you can reasonably afford, both in terms of what income and assets you have available to help and what student loan amount will be manageable for your child.

Reach out to a Plancorp advisor today to create a 4-year college budget and determine which financing options make the most sense for you and your family.

Additional Resource:

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Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

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Derek joined Plancorp in 2018 after spending the previous three years of his career as a financial advisor in Boulder, Colorado. As a CERTIFIED FINANCIAL PLANNER™ professional, he is passionate about helping people make financial decisions tailored to the life they want to live. More »