If you have a student loan, here’s what happens when the Fed lowers rates

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If you borrowed money to attend college, you likely won’t feel any impact if the Federal Reserve cuts interest rates. That’s because most Americans with student loan debt have fixed interest rates, which means that payments don’t change for the life of their loan.

But not all borrowers have student loans with a fixed rate, and those with variable interest rates will see changes any time the Fed makes cuts. If you have private student loans with variable interest rates, here’s how the Fed rate cuts might impact you.

Key takeaways

  • Interest rates on federal student loans are always fixed. These rates are set on July 1 each year for loans disbursed from July 1 to June 30 of the following year.
  • Federal student loan interest rates are determined based on the high yield of the last 10-year Treasury note auction in May, plus a margin that varies based on the type of federal loan.
  • Borrowers with existing federal student loans will not see any changes when the Fed lowers interest rates.
  • Borrowers with variable-rate student loans from private lenders may see their interest rate drop when the Fed makes cuts.

How interest is calculated on a student loan

All student loans require borrowers to make interest payments, and this is true whether you have federal or private loans. Even so, the way the interest is calculated depends on the type of loan you utilize, who your lender is and the type of rate you have. Federal student loans have fixed interest rates, or rates that don’t change for the life of the loan. If you have private student loans, you could have fixed or variable interest rates, or rates that fluctuate based on the Fed rate.

Federal student loans

Congress determines interest rates on federal student loans, and those rates change every year. The type of loan you have and when you borrow will determine your interest rate, but the interest rate for each type of loan is the same for all borrowers regardless of credit score or financial profile.

For undergraduate borrowers who take out a Direct Subsidized or Unsubsidized Loan starting July 1, 2020, and before July 1, 2021, interest rates are set at 2.75 percent. Meanwhile, graduate and professional borrowers will pay 4.3 percent on Direct Subsidized Loans, and Direct PLUS Loan borrowers will pay 5.3 percent.

Private student loans

Interest rates for private student loans are determined by your creditworthiness. If you have a strong credit history, you could get the lowest interest rates offered. This goes for both fixed- and variable-interest-rate loans.

Variable interest rates mean that your interest rate — and in turn, your monthly payment — can change depending on the Fed rate. The Fed rate is the result of what banks charge each other to borrow and lend money when they make transactions overnight.

Private student loan lenders use the London Interbank Offered Rate (Libor) on top of an average market rate. Variable interest rates tend to start out lower than fixed interest rates but have the potential to increase if the Fed rate goes up.

How Fed rates impact student loan interest

Not all student loans are affected by the Fed rate. Your personal impact will depend on the type of loan you have and the type of interest rate you’re charged.

If you have a federal student loan

While the federal funds rate isn’t the exact interest rate you’re charged for taking out credit, it serves as a benchmark for the rates you have to pay on loans, such as credit cards and auto loans. Essentially, if the Federal Reserve hikes or cuts the fed funds rate, interest rates on those loans respond in kind.

That’s not the case for federal student loans. Lawmakers meet annually to determine interest rates for loans taken out during each subsequent school year. For instance, policymakers met last spring to determine how much it’ll cost to take out a student loan between July 1, 2020, and June 30, 2021. They’ll also do the same this spring in an effort to determine rates for student loans disbursed from July 1, 2021, to June 30, 2022.

Even though the Fed doesn’t have direct control over student loan interest rates, you might start to see them react the same way. That’s because Congress ties interest rates to external market forces, mainly to the 10-year U.S. Treasury yield. The same factors influencing those returns are also dictating Fed officials’ decision-making.

The bottom line: Federal student loans you’ve already taken out won’t see any impact. However, students borrowing money for the 2020-21 school year can benefit from some of the lowest rates in over a decade.

If you have a variable-rate student loan

If your student loan has a variable interest rate, you’ll feel the Fed rate changes the most. When the Fed raises or lowers borrowing costs, your interest rates will likely respond.

Most student loans with variable rates come from private lenders that set their own rates. However, private student loan interest rates are pegged to the federal funds rate, so they typically respond to any Fed adjustments. Some loans could be tied to the prime rate, which is also tied to the federal funds rate.

The bottom line: Variable interest rates are tied to the Fed rate. When the Fed rate goes up, your interest rate goes up and you’ll face a higher monthly payment. When it goes down, you could pay less per month.

What you should do if your student loan rate is variable

If you have a student loan with a variable interest rate, the Fed lowering interest rates may leave you with a lower monthly payment. However, the opposite is also true, and your payment can surge in an environment where interest rates are rising.

It’s important to read the fine print on the terms of your loan, especially if you have a variable rate. That includes seeing if your lender has a cap on how high or low the interest rates can go.

With rates falling, you might want to refinance your student loans. If you shop around for the best rate, you could save money by shaving off a percentage point or two from your interest rate. If you have enough student debt and are able to refinance it all, you could save hundreds or thousands of dollars over the life of your loan.

When to refinance

Regardless of whether you have federal or private student loans, you have the option to refinance your loans to get a better deal. Refinancing is the process of taking out a new loan with a new interest rate and repayment terms, paying off your old loans and then making one payment to your new loan.

You should refinance your student loans if:

  • You have a solid credit score. Since you’re taking out a loan with a private lender, your credit score and credit history will determine your new interest rate. If you don’t have an excellent or even good credit score, your interest rate will be higher than that of someone who has a better score.
  • You have private student loans. Federal student loans come with a number of protections, like deferment, forbearance and income-driven repayment plans. Those go away when you refinance. If you have private student loans already, you don’t stand to lose these benefits.
  • You’ll get a lower interest rate. If you have a high interest rate — whether it’s fixed or variable — a good chunk of your monthly payments might be going toward interest instead of your principal balance. If you can secure a lower interest rate, you’ll get a lower monthly payment. If you’re struggling to make payments now, this might be your biggest determination for refinancing.

Next steps

Fed rate adjustments could impact your student loans, but whether those impacts are positive or negative depends on which type of loan you have. Consider the following steps based on your situation:

  • If you have federal student loans: If you have federal student loans and you’re happy with your monthly payment and repayment timeline, there’s nothing you need to do. While interest rates are incredibly low right now, federal student loan borrowers currently benefit from a 0 percent interest period due to the coronavirus, so refinancing doesn’t make sense in most scenarios.
  • If you have fixed-rate private student loans: If you have private student loans with a fixed interest rate, you may have taken out your loan when Fed rates were higher. Check with lenders to see whether you could refinance into a new loan with a lower fixed rate.
  • If you have variable-rate private student loans: If your student loans currently have a variable rate and the Fed makes cuts, you may want to see if you can refinance your private student loans into a new loan option with a fixed rate equal to what you’re paying now. Doing so could help you lock in your rate and protect you from rising interest rates in the future.

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Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Student loans editor