The U.S. student loan market is estimated to be worth around $1.762 trillion. And with the Federal Reserve making headlines all year, many students are asking — what do higher interest rates mean for my student loan? Let’s start by looking at some statistics. This is a big issue — total student loan in the U.S. is currently over $1.7 trillion. Though on the bright side, “The debt accumulation rate is slowing, and recent analytics indicate that consumers responsibly manage their student loan debt.”
But 43.4 million borrowers have federal student loan debt, the average federal student loan debt balance is $37,014 and in the first quarter of 2022 91.2% of all student loan debt was federal. The rest 8.8% belongs to private borrowers.
The Federal Reserve has already started making the cost of money higher and is expected to raise the funds rate from the current target rate (0.75%-1.00%) to about 3.5% in 2023.
What do higher interest rates mean for student loans? The answer lies in the type of student loans. I’ll analyze the implications below.
Does Raising Interest Rates Affect Student Loans?
How rising interest rates affect student loans depends on the type of loan — if you have a fixed-rate or a variable-interest-rate loan.
If you have a fixed-rate loan, then a higher interest rate will mean nothing to you as long no clause exists that says for example your rate will adjust to reflect the inflation rate. If your terms and conditions say that you must pay, for example, 4% fixed interest rate, then you are safe and should not worry if the Federal Reserve increases the funds rate. You will not be affected. Chances are you have one of the four types of federal student loans.
What if you have a variable private interest rate loan? Then you should be concerned, as you will see the cost of the loan increasing following the Federal Reserve rate hikes.
Is a Fixed-APR Student Loan Better Than a Variable APR?
In most cases, the answer is yes, a fixed-APR loan is better. Getting a fixed APR (annual percentage rate) means you have a rate that will not change in response to broader economic conditions. The good news is that federal student loans offer a fixed rate. As mentioned above, they are the majority of student loans in the U.S. market.
It is notable that “On April 6, 2022, the U.S. Department of Education (ED) extended COVID-19 emergency relief for student loans through Aug. 31, 2022,” with key highlights a suspension of loan payments, a 0% interest rate and stopped collections on defaulted loans.
The current interest rate for federal student loans is 3.73% for Direct Subsidized Loans and Direct Unsubsidized for undergraduate students, and for graduate or professional students, the interest rate for Direct Unsubsidized loans is 5.28%.
Is It Better to Have a Higher or Lower Interest Rate on a Loan?
The answer is a lower interest rate. But the key is to read the terms and conditions.
In an environment of falling interest rates, having a fixed-interest-rate loan is a bad idea. You should search for the option to refinance your loan in those circumstances.
We are not now in a falling interest rate environment, but checking the terms and conditions is always a wise idea.
Private student loans evaluate your credit score and adjust the interest rate accordingly. I estimate that it will be tough to find better overall conditions in a private student loan compared to a federal one. Even if you get a 5.28% interest rate by a federal student loan, the rate is considered a logical one, it is fixed, and you will be insured against any interest rate hikes in the future. So, the fixed federal student loan seems to be the best choice now.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.