How Does Interest Rate Factor Into College Loan Costs?

 

When you’re calculating college costs, you can’t forget about the interest rate.

Well, you can forget, which is the problem with all loans. You stare at the sticker price on a car, and consumers often don’t think about the interest rate attached. You buy a $200,000 home, for instance, and you don’t think about the 3.92 percent interest rate — meaning that the total cost of the home over 30 years of payments is actually $340,427.

Student loans are similar in that sense. You may know that you’re going to borrow, say, $30,000 for college, but of course, you’re going to pay back more than $30,000.

Which is perfectly normal, of course. Still, what that interest rate is matters. The higher the interest rate, after all, the more you pay back over the life of the loan.

So, if you’re thinking about student loans but not thinking about interest rates, start thinking about them. You’ll want to keep the following issues in mind.

Most federal student loans have fixed interest rates. Some of you reading this may be headed to college, and you haven’t had to do much thinking, fortunately, about interest rates and money; others reading this may be parents of college students, and if this is very familiar territory, start skimming the next two paragraphs, guilt-free. But in case you are just coming up to speed with some of these terms, here’s a quick explanation of what a fixed interest rate is.

A fixed interest rate means that if you’re paying, say, 5 percent to take out a loan, the cost of taking out that loan will remain 5 percent for the entire time. Most personal finance experts will tell you that this is a good thing. If you’re paying $101 a month (just to pull a hypothetical number out of a hat) to a financial institution for your student loans, you’ll always pay $101 until the loan is paid off. It’s no fun paying anyone $101 a month, but at least there won’t be any big surprises later.

A variable interest rate means that the interest rate may change as the economy improves or worsens; so that 5 percent interest rate could drop to, say, 3 percent, and maybe your $101 loan payment drops to a refreshing $89 a month. And now you’re thinking, “Well, hey, that’s awesome. What’s the problem? Sign me up.” But your 5 percent interest rate could climb to 9 percent, depending on how things go with the economy, and suddenly instead of paying $101 a month, you’re paying $143 a month on your student loans.

Most personal finance experts will tell you that it’s smarter to stay away from the variable loans — especially if you fear that you won’t be super-rich (or at least for a while). The economy may be doing great when you take out a student loan with a variable interest rate, but who’s to say that the economy will stay great for the next, say, 10 or more years or however long it takes you to pay your loans off?

Many private student loans come with both fixed and variable interest rates. So, you have read the above and may have muttered to yourself, “OK, fixed interest rates good. Variable bad. I’m just going to go with federal student loans.”

But actually, that may not be the right call.

Many consumers opt for federal loans because if you have trouble paying them off, the government is generally more merciful about it than the private investors are. (Oh, don’t get too excited. You still have to pay off federal student loans. But they’ll give you more grace periods and more consumer-friendly options than the private loans.)

That said, if federal loans, scholarships, and grants don’t cover all your expenses, you may need to explore the possibility of private loans, and there are a lot of choices out there. Some private loans have very reasonable terms, so you shouldn’t dismiss them without shopping around and seeing what you can find.

Your credit score matters when it comes to private loans. Mostly, when you’re in the process of being approved for federal student loans, it comes down to the actual financial need for student aid and not your credit history (the exception is the Direct PLUS loans for parents and graduate and professional students, where credit scores do come into play).

With private loans, however, your credit score does become a factor, and so if your credit score is in tatters, but you are approved, your interest rate will likely go up, and so will the cost of your loan. And, as noted, that matters.

As online student loan calculators can show you, if you have a private loan of $30,000 with a 9.66 percent interest rate (currently, the average private loan interest rate), that means you’ll be paying back $46,898.70.

That’s a lot, regardless, but if your credit isn’t great, and you’re approved at, say, 15 percent, you’d be paying an even more frightening $58,081.36.

Maybe in the end, you’ll wind up taking out some college loans with less than appealing interest rates. But you certainly want to be paying attention to those interest rates and thinking hard about them. It’s one thing if you’ve done your comparison shopping and feel that you’re going to have to take on some student loans with punishing interest rates. But at least you’ll go into the loan with a full understanding of how costly it will be.

If you have additional questions about student loans and your options for paying for college, visit CFNC.org or call us at 866-866-CFNC.