Do student loan interest rates follow the Fed's decisions?

With the fall semester around the corner, many students are wondering what to do about student loans. In today's inflationary environment, many students and their families are already stretching their budgets.

To try to curb inflation since 2022, the Federal Reserve has been significantly raising the federal funds rate, which is the rate banks charge each other for overnight loans. As borrowing costs get more expensive for banks themselves, that can then influence interest rates for things like car loans and credit cards, as well as yields on Treasury securities.

Student loan interest rates, both federal and private, have also generally gone up during this period. However, it's important to note that many types of interest rates, including student loan rates, do not directly mirror the Fed's actions. That's because the Federal Reserve does not directly set student loan interest rates, even for federal loans. The Fed's actions generally influence broader interest rates, but there can be other factors at play, and rates don't always move in lockstep.

So, while there's some debate as to how much the Fed will continue raising rates in 2023—and whether the trend will reverse next year—you might not want to base student loan borrowing decisions based on what the Fed may or may not do.

"Most students are probably better off choosing the best financing options in the present rather than trying to guess the Fed's and economy's moves a year from now," says Elizabeth Pennington, CFP, senior associate at Fearless Finance.

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What drives federal student loan interest rates?

Federal student loan interest rates follow a set formula. The 10-year Treasury note is used as a baseline, with fixed markups added based on the type of federal loan.

For example, for loans disbursed between July 1, 2023-June 30, 2024, the 10-year Treasury yield of 3.448% was used as the baseline. Direct Subsidized and Direct Unsubsidized Loans for undergraduates have a 2.05% add-on fee, so the fixed rate for these loans totals 5.50%.

In comparison, for loans disbursed from July 1, 2022-June 30, 2023, the 10-year Treasury rate used at the time was 2.943%. The add-on for Direct Subsidized and Direct Unsubsidized Loans remains constant at 2.05%, so that meant the total fixed rate was 4.99%.

In other words, the difference of about half of a percentage point over the past year can directly be explained by a corresponding change to the underlying 10-year Treasury rate, which doesn't exactly follow the Fed funds rate. "Those Treasury note rates are set by auction," says Pennington. "So while the Fed's changes are going to affect the market for Treasury notes, so will expectations about future Fed rate changes."

Expectations about the economy as a whole can also affect the market for Treasury notes, as well as impacting Fed rate changes, she adds.

What drives private student loan interest rates?

Similar to federal student loans, private student loans are generally influenced but not set by the Fed.

"Any change the Federal Reserve makes in rates is likely to impact market indexes, which are used by lenders to determine interest rates. As the federal rate goes up, the cost to borrow is likely to follow, and when rates go down, interest rates are expected to fall," says Angela Colatriano, chief marketing officer at College Ave Student Loans.

Private student loan rates can be either fixed or variable, whereas federal student loans are always fixed. And unlike federal loans that strictly use the 10-year Treasury rate to base rates on, private lenders can differ in terms of underlying benchmarks and the formulas they use to come up with actual rates.

"That means that at times, private student loan rates are significantly lower than federal loan rates because market conditions dictate a different rate than the federal loan rate formula," says Pennington. "At other times, federal loan rates are more competitive because of generally high lending costs in the private market."

In many cases, private lenders use the same underlying benchmarks to establish rates, like the Secured Overnight Financing Rate (SOFR). But they can have different markups.

"At the end of the day, private lenders are picking rates that keep them competitive in the market," adds Pennington.

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Choosing what works best

Just because Fed rates rise or fall doesn't mean that all student loan lenders follow suit, so it's important to compare your options.

"Shop around to understand what rates you qualify for and pay attention to the monthly payment to make sure it feels reasonable for your budget," says Colatriano.

If you have a good credit score, for example, you might qualify for a lower rate than the headlines might indicate.

"Private lender rates are in part based on credit scores, while federal rates are not. So in 2021, for example, I'm sure there were borrowers with excellent credit who could get significantly lower rates privately vs. federal," says Pennington.

Now, with rates relatively high, you might be tempted to sit on the sidelines to see if they come down before applying for student loans. But that can get tricky.

"The past few years have shown us that predicting market activity can be very difficult, if not impossible," says Pennington.

Even if you do take out student loans now and then rates fall in the future, you might then be in a position where refinancing makes sense.

Federal student loans can't be refinanced through the government, but you could refinance them with a private lender, thereby converting them into private loans. Doing so means forgoing federal student loan benefits, like the potential for federal student loan forgiveness, but it might lead to finding a better rate.

Before you get that far, though, analyze your different college funding options and see what makes sense for your finances.

"Before they borrow, families should exhaust 'free money' such as scholarships and grants, as well as look at what they can contribute via their savings and income," says Colatriano. 

"If they need to borrow, use federal student loans in the student's name first as those come with a low fixed rate and unique benefits and protections. Federal loans in the student's name do have annual borrowing limits, and that is where private student loans can help close the gap," she adds.

Check your private student loan options here now to learn more.