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For several years, low interest rates on government bonds benefited borrowers taking out new federal student loans. But in 2018, rates are headed up for the second year in a row.

Increased rates for new borrowers — which take effect July 1, and will be in place for one year — could signal the end of an era of low rates. Since a 2013 overhaul of the Higher Education Act, interest rates on newly-issued federal direct loans are benchmarked to 10-year Treasury notes, and reset annually.

The 2.995 percent yield on 10-year Treasury notes auctioned May 9, 2018, means rates on federal direct loans to undergraduates disbursed on or after July 1, 2018 and before July 1, 2019 will be 5.05 percent, up from 3.76 percent in 2016. Rates on federal direct loans to graduate students will increase to 6.60 percent on July 1, and rates on PLUS loans will rise to 7.60 percent.

Since rates on federal student loans are fixed, existing borrowers will continue to pay the same rate, unless they qualify to refinance their loans at a lower rate with a private lender.

It costs about $36,227 to repay $30,100 in direct unsubsidized federal student loans at 3.76 percent interest under the standard 10-year repayment plan. If a borrower were to take out the same amount of government loans at the new interest rate of 5.05 percent, they’d be looking at about $2,240 in additional repayment costs — or $38,400 all told.

The Department of Education recalibrates rates on federal student loans once a year, adding 2.05 percentage points to the rate for 10-year Treasury notes auctioned in May to establish rates for new loans to undergraduates. The add-on for federal direct loans for graduate school students is 3.6 percent, while rates for parent PLUS loans equal yields on 10-year Treasury note plus an add-on of 4.60 percentage points.

Yields on 10-year Treasurys are coming off of historic lows as the global economy continues to recover from the 2008 mortgage meltdown and recession. Treasury yields are determined by investor demand for government debt, and could shoot up if economic growth heats up and fears of inflation sour investors on bonds.

No matter how sharply Treasury yields climb, legislation implementing the formulas for federal student loans caps rates at 8.25 percent for undergraduate loans, 9.5 percent for graduate loans, and 10.5 percent for PLUS loans.

Federal funds rate vs. 10-year Treasury yields

The Federal Reserve has been gradually raising its target for a key short-term interest rate, the federal funds rate. As the chart above demonstrates, long-term rates like 10-year Treasury notes don’t track short-term rates like the federal funds rate exactly, but there is a correlation.

Private lenders offer both fixed and variable-rate student loans. The two most commonly used indexes for variable-rate student loans are the London Interbank Offered Rate (LIBOR) and the prime rate, which track the federal funds rate tightly.

Rates on government student loans don’t take into account the credit risk posed by the borrower. Borrowers with good credit may qualify for better rates from private lenders, particularly if they have graduated and are earning a steady income.

Many private lenders now offer education loans to parents that are competitive with federal parent PLUS loans, which carry a 4.276 percent up-front disbursement fee that’s not charged by private lenders. Parents with high-interest government loans can often refinance them with private lenders at lower rates.

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A recent survey commissioned by Discover Student Loans found that more than three out of four families expect to help pay for their children’s college. But only one in five families say they’ll be able to pick up more than half of the tab, and most (55 percent) said they expected their child would have to rely on student loans for funding, up from 50 percent in 2013.

Credible is a multi-lender marketplace that allows borrowers to request competitive student loan offers from vetted lenders, without affecting their credit scores.

About the author
Matt Carter
Matt Carter

Matt Carter is a Credible expert on student loans. Analysis pieces he’s contributed to have been featured by CNBC, CNN Money, USA Today, The New York Times, The Wall Street Journal and The Washington Post.

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