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Like mortgages and credit cards, student loans come with interest rates. These can be fixed or variable depending on the loan type. They can also cause you to pay significant amounts of extra money over the long haul. As of the end of 2022, the average student loan debt is $37,574, according to a study by BestColleges.com. With figures as high as that for many Americans, it’s important to understand how student loan interest rates work.
How student loan interest works
Let’s get back to basics. What is an interest rate? It’s the percentage of the loan amount that a creditor charges a borrower. Interest rates are usually expressed in terms of an annual percentage rate (APR). The APR takes into account not just the nominal interest rate on a loan but the fees as well. That’s why it gives you a more realistic picture of what you’ll pay to borrow money.
Student loan interest rates are different depending on whether you have federal student loans or private student loans. The short explanation is that federal student loans are a better deal.
Want low-interest student loans? You’re better off going for federal loans. Their interest rates are determined yearly and are always fixed, meaning they won’t change over time. They’re also capped, meaning they have to stay below a certain percentage that Congress votes on.
Private student loan interest rates, on the other hand, can be fixed or variable. If you have a variable interest rate, that interest rate could go up or down. In a low-interest rate environment like the one we’re currently enjoying, getting a variable-rate loan means you’re almost definitely going to face an interest-rate hike in the future. Whether it’s a home loan or a student loan, a variable rate is a bigger risk.
Student loan rates: Looking ahead
Addressing the student debt crisis has become a hot political issue. As the cost of college increases and a college degree becomes ever more necessary in order to find a middle-class job, average student debt is rising, too. Some politicians want to automatically enroll student borrowers in income-driven repayment plans. Others want to allow folks with student loans to refinance their loans and get a lower interest rate. Time will tell whether these proposals get off the ground.
It’s worth noting that the relationship between student loan size and default is counter-intuitive. The folks with the biggest student debt loads are the ones least likely to default. This is likely because their large debts come from law school or medical school and therefore position them to take up high-earning jobs that provide them with the income they need to repay their loans.
People with small amounts of student debt may have gone into lower-paying professions, or may not have gotten their degree at all. That leaves them less able to make their monthly loan payments and more likely to default. As with refinancing a mortgage, refinancing student loans is more valuable to those with larger loans. That means that better-off borrowers would benefit from a change to the refinancing rules more than working-class borrowers.
Student loan interest and your budget
Many borrowers struggle with the question of how to fit student loan payments into their budget. The answer depends on your income, expenses and interest rates. The big quandary many people face is whether they should devote extra money in their budgets to making student loan prepayments or to saving for retirement. Saving for retirement early lets your money compound over time. On the other hand, paying off debt brings a huge sense of relief and frees up money in your budget.
If your student loan interest rate is high (say, over 8%), you may want to focus on paying it off. If you have low-interest college loans you can probably afford to save for retirement at the same time that you chip away at your student debt. And of course if you have access to an employer match to your 401(k) you should contribute up to the maximum match amount if possible.
While paying off debt feels good, the savings pale in comparison to what you’ll gain from taking an employer match.
Bottom line
Student loan interest rates have a sizable effect on the affordability of your debt. A good student loan calculator can show you how prepayments can help you get out of debt more quickly. Any time you take on debt you should be ready to make timely payments every month.
Taking on student loans without a plan is not a wise move. If you go for a variable-interest loan, make sure you can afford the payments if the interest rate were to rise. Your first point of access for student loans is to fill out the FAFSA, the Free Application for Federal Student Aid. Then, you’ll be able to see any funding gaps that you’ll have to fill.
Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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Tax planning is one reason investors seek the help of a financial professional. Learn how SmartAsset can help you find clients looking for advice.
