Everyone has a general concept of what interest rates are, and how they impact loans.
However, if you gave someone a pad of paper and a pencil and told them to write out a problem showing how interest rates work, you’d probably just wind up with a giant drawing of a question mark.
Now imagine you’re asking an 18-year-old high school senior to do the same.
Interest rates are tricky, especially when it comes to student loans. That’s why it is so important to understand interest rates, how they apply, and what it can mean about the ‘true’ cost of an education. Because if there’s one thing that is universally accepted about interest rates, it’s that they’re becoming drastically less ‘interesting,’ and more excruciating, if you don’t understand the costs beyond what you are actually receiving each semester in disbursements.
Interest Rates 101
The first step in figuring out how interest rates apply to your student loans is to make sure you understand the concept of interest rates. It’s not just as simple as multiplying the rate by the amount borrowed–interest rates compound annually, meaning you accrue interest every year so long as you still have a balance.
It’s not a one time fee, it’s an annual rate assessed to your remaining balance.
It’s also important to understand how interest rates are set. The base rates are a product of the Federal Reserve and Congress, who work together to set the interest rates on federal student loans and cap the interest rates that other borrowers can charge. When it comes to private loans, a student’s credit comes into play.
If a student has a credit score favorable enough for the lender, it can lead to a lower rate, but if a student hasn’t had a chance to establish credit or has derogatory marks, a cosigner may be required.
That means someone else has to be on the line if you don’t have a lot of credit, have missed payments or have maxed out credit lines. Even with a cosigner, banks may still be wary about lending to students without much financial history, so private loans often come with higher rates.
This is also a good time for a quick refresher of the difference between fixed and variable interest rates on loans. A fixed rate means the interest will never change, while a variable rate can shift based on the number of payments, the borrower’s credit score or other factors laid out in the terms of a loan.
Understanding Interest Repayment
Beyond the rate itself, the next step is sizing up paying off the interest. For subsidized federal loans, which are given to students with financial need, the government will pay the interest payments while the student is in school. For unsubsidized federal loans, students can defer interest payments while in school, or during a deferment period, but that interest amount then becomes part of the principal balance.
The key part in paying off interest is understanding how that process impacts the accrual of interest. The amount you generate in interest goes down the quicker you pay off interest. That allows you to start paying off the principal balance, and as your loan decreases in size, the amount of interest you have to pay before you get to the principal portion shrinks.
For a loan with a fixed rate, paying down the principal balance is the only way to reduce the amount you owe in interest, and to start to work towards total repayment. That is, unless you look into refinancing options.
Read more: The Perks of Paying Off Interest
Getting a Better Rate
In a lot of articles about debt and student loans, you’ll see that magical ‘refinance’ word, but it’s not often discussed in detail. So what does it mean? Refinancing a loan means you are renegotiating the interest rate/terms by paying for the balance of one or many loans with a new loan.
Why is this necessary? Interest rates. Even with a fixed-rate loan, conditions can change, and sometimes refinancing makes the most sense. It can be societal-wide changes, like interest rates dropping to encourage individuals to borrow more money and jolt the economy, or more personal changes, such as seeking to consolidate the loans of a recently married couple.
Here’s the important thing to remember: Federal student loans cannot be refinanced, unless a student seeks out a private loan to do so.
No matter what route you go with student loans, interest rates play a crucial role in how those loans affect repayment. But by understanding these rates, and putting together a financial plan adapting for all of your interest options, it’s possible to minimize the effect student loan interest will have on your financial future.