Financial Literacy Series: What’s behind your student loan interest rate? | 04.12.12

Posted in Financial Aid, Private Student Loans, Student Credit, Student Loans By Student Loan Network Staff

Piggy bank with blackboardIn last week’s blog “Know your student loans” I talked about some of the basic student loan terms you’ll need to know when choosing the best financial aid option. Included in the article were the basics of student loan interest rates. This week I want to break down interest rates even further to help you understand why banks charge what they do and how this is determined.

How interest rates are determined

The first thing you might notice during your financial aid process is that not all interest rates are created equal, even federal ones. Federal Stafford loans are currently at very low rates of 3.4%, while federal PLUS loans are at 7.9%. Even amongst private loans, the lowest available rates can vary significantly. But why is this?

For starters, the lowest advertised rates are not what most people get. You and everyone you know must have perfect credit to get these rates (not literally, but it might as well be). These low rates offered by lenders are based on external factors like PRIME or LIBOR indexes, and the stock market, as well as some internal factors such as how the bank invests its funds or even the business model the bank uses. The bottom line: banks determine their lowest interest rates based on what will keep them competitive in the market, while still being profitable.

How banks determine YOUR interest rate

When a bank or financial institution lends out money, there is substantial risk involved, especially with student loans where banks have no collateral like they would for a mortgage. Each bank calculates their risk differently depending on their own resources and business goals.

When determining the risk of loaning money to someone, banks look at a variety of factors, and each bank will weigh the criteria differently. Here is what banks generally look for when figuring your interest rate:

Loan specifics – Things like how much you borrow and how long you wish to repay can impact risk, and therefore your interest rate.

Borrower credit – This is a biggie. Lenders look for a variety of items when assessing credit, not just your score. Data they will look at include income, employment and credit history, credit score, and other types of debt you may have. These factors together help a lender to assess if a borrower will be high or low risk.

If you’re a student you may be thinking “what if I don’t have a history of employment or steady income? Will I still be able to get a loan?” The short answer is maybe.

Student loans are different from most other types of loans in that the borrowers tend to be much younger, and therefore have not developed a strong credit history. This is why it’s always best to apply with a cosigner such as a parent or guardian. A student applying for a loan by themself is a much higher risk than one who applies with a cosigner. This means that not only does applying with a cosigner increase your chance of being approved, but the better your cosigner’s credit, the better the interest rate will be.

What it all boils down to

  1. All private lenders will offer you different rates for student loans. Apply for a few and pick the best option for you.
  2. Your credit matters. Fix any credit reporting errors or take steps to improve your credit before you apply. To do this, start by requesting your credit report.
  3. Apply with a cosigner. Your interest rates will be lower, and you’ll save money in the long run.

Now go forth and make smart financial choices! Don’t forget to check back next week for our third post in this Financial Literacy Blog Series: Budgeting in college.

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