The financial markets were shook this week as China crumbles and rumors of a Federal Reserve interest rate hike surface once again.
By now, I’m sure that we all know that student loans are a huge problem in the United States. It is crazy to think that student loan debt is the second largest type of consumer debt, only behind mortgage debt. Over the last decade, outstanding student loan debt has risen at a remarkable pace. Today, $1.2 trillion in student loan debt is outstanding and most graduates find themselves with an open tab.
The current low interest rate environment has been extremely friendly to student loan borrowers. Lower interest rates largely equal lower student loan payments which leads to higher levels of discretionary consumer spending. Exceptionally low interest rates have started to feel like the new normal in the United States.
But what were to happen if interest rates started to rise? What would rising interest rates mean for student loan borrowers?
A Federal Reserve interest rate hike is looming and the consequences for student loan borrowers are significant. Many consumers tend to only think about the present, many consumers forget to consider what would happen if interest rates began to rise. Let us look at the consequences of rising interest rates for student loan borrowers.
Federal Student Loan Borrowers
The majority of new student loans are issued by the Department of Education. Odds are, if you have a student loan it is a federal student loan. Luckily, rising interest rates wouldn’t have much of an effect on already issued federal student loans.
Federally issued Stafford, Perkins, and PLUS loans all have fixed interest rates. Meaning, even if interest rates rise dramatically, the rates on these loans will remain constant. Your monthly payment and loan cost will not be affected by rising interest rates.
However, if you are looking for a new federal student loan you may be affected. In 2013, congress voted to set federal student loan interest rates as a function of market interest rates. Most federal student loan rates are determined by the final auction of the 10-year Treasury notes each May. Most recently, the rate on federal Stafford loans for undergraduates will be 4.29% for the 2015-2016 year, down from 4.66% on loans given out during the 2014-2015 school year.
So if we begin to see Treasury rates rise, you can surely expect that new federal student loan interest rates will follow suit.
Private Student Loan Borrowers
Unlike federal student loans, private student loans are issued with both fixed and variable interest rates. The borrower selects the interest rate type on private student loans. If you selected a fixed rate, your monthly payment, interest rate, and total loan cost will be unaffected.
However, if you selected a variable rate, you may be at risk. Variable interest rates vary with an underlying index. Most variable private student loans adjust with the interest rate index known as LIBOR. If LIBOR begins to rise, expect to see your monthly payment, interest rate, and total loan cost to rise too. Variable rates usually reset on a monthly or quarterly basis.
Your monthly private student loan payment is probably about as low as it can get right now. If you find yourself cutting your monthly budget too close, rising interest rates might make matters complicated.
Hybrid Rate Student Loan Borrowers
A number of new student loan refinance lenders have started adding mixed rate options. What is a mixed rate? A mixed or hybrid rate is fixed for a short period of time, then adjusts to variable. For example, the first five years of a hybrid student loan may have a fixed interest rate. But then for the remainder of the loan (last five years), the rate may vary monthly along with the 1-month LIBOR.
If you refinanced a few years ago to a hybrid rate, you might want to consider refinancing again. Why? Your fixed rate period might be almost over. When your loan adjusts to a variable rate, rising interest rates would affect your monthly payment and total loan cost.
How to Protect Yourself
As mentioned above, student loan refinance has become a very hot topic. What is student loan refinance? Student loan refinance is the process of refinancing old student loans into a new student loan with a private lender. You can refinance both federal and private student loans, and most lenders offer variable and fixed rates.
If you are currently locked into a variable rate with a private student loan lender you should consider refinancing with a fixed rate. Even if you aren’t able to lower your interest rate or monthly payment, refinancing to a fixed rate has its benefits. Refinancing to a fixed rate goes a long way in adding certainty to your monthly budget. With a fixed rate you won’t need to worry about your monthly payment or total loan cost changing.
Furthermore, it is a great time to refinance student loans. Low interest rates equal low student loan refinance rates. There are a number of refinance lenders who offer rates as low as 1.92% on the variable product, and 3.50% on fixed student loan products. Even if you have a fixed rate federal student loan, you might be able to lock into a potentially lower rate.
Low interest rates are great for consumers, but higher interest rates will certainly come in the future. Be ready for rising rates and take advantage of low rates by refinancing your old student loans.