With federal student loans, everyone pays the same interest rate, regardless of their credit scores. With private student loans, on the other hand, your credit score (and the credit score of your cosigner) has a major impact on what interest rate you ultimately pay. If you have excellent credit, you may even qualify for a lower interest rate that is competitive with the fixed interest rates on federal loans.
How are Private Student Loan Rates Set?
Rather than setting rates according to a formula decided by Congress, most private lenders base borrower interest rates on the prevailing LIBOR rate. The LIBOR index reflects market rates and economic conditions, so it can fluctuate, thereby changing the interest rates offered to borrowers.
Lenders often base borrower interest rates on the LIBOR index because the lender’s cost of funds are also often based on the LIBOR index, yielding a predictable spread between the two interest rates.
In addition to the LIBOR index, lenders add a fixed margin based on the borrower’s credit score and the credit score of the cosigner. For example, a borrower’s interest rate on a variable-rate loan might be described as 3M LIBOR + 4.25%, where 3M LIBOR is an average of the LIBOR index over a 3-month period and 4.25% is the fixed margin.
Even for variable interest rates, the interest rate formula is fixed when the loan is made. A subsequent change in your credit score will not affect the interest rate you are charged. However, a variable interest rate will increase and decrease with changes in the underlying index rate. If your credit score has improved, you might be able to get a better interest rate by refinancing your student loans.
Credit Score Tiers
So, how does the lender translate the borrower’s credit score into the fixed margin part of the loan’s interest rate?
Most private lenders group credit scores into five or six tiers. Each tier corresponds to a non-overlapping range of credit scores. Each tier is mapped to a specific fixed margin, which is added to the index rate to yield the interest rate on the loan.
Credit scores predict the likelihood of non-payment, so the interest rates are set to compensate for the higher risk of delinquency and default.
Thus, your actual loan interest rate depends on the credit tier you fall into. A better credit score yields a lower margin and therefore a lower interest rate. In order to get the lowest advertised student loan rate, your credit score needs to be in the highest tier.
Impact of Tiering of Interest Rates
There are several consequences of the grouping of interest rates into credit score tiers.
- If your credit score is at the edge of a tier, a slight change might shift you into a different tier, leading to a different interest rate.
- In some cases, a slight improvement in credit scores can yield a big change in the interest rate, perhaps as much as three percentage points. This is why it can be worthwhile to have a cosigner even if you can qualify for the loan on your own.
- The typical width of a tier can be as much as a 40-50 point difference in the credit score, about the same as the change in credit scores from a delinquency.
- The credit tiers do not depend on the amount borrowed.
Do You Qualify for the Best Student Loan Interest Rates?
For the most part, private lenders don’t release their tier information. They consider the number of tiers, the ranges of credit scores and the mapping from tiers to interest rates to be trade secrets.
It’s fairly typical, though, for less than 10% of a lender’s borrowers to qualify for the lowest advertised rates. Most borrowers will not get the lender’s best advertised rate. Instead, more borrowers will get the lender’s highest interest rate than get the lender’s lowest interest rate.
Many college students don’t have established credit scores high enough to qualify them for the best private student loan rates or to even qualify for a private student loan on their own. More than 90% of private student loans to undergraduate students and more than 75% of private student loans to graduate students require a cosigner.
A well-qualified cosigner, however, can help you get a better loan offer. If you can find a cosigner with a higher credit score, you might be able to get a lower interest rate. Most private student loans are made based on the strength of the cosigner’s credit, not the student’s.
How to Improve Your Credit Score to Get a Better Interest Rate
While you don’t need to worry about your credit score when getting federal loans, there’s a chance that federal loans won’t be enough to cover your college costs. It’s been more than 10 years since Congress increased the cap on federal student loans. In fact, two-fifths of college students exhausted their eligibility for federal borrowing in 2015-16.
So, even if you get federal student loans to cover most of your college-related costs, you might need private student loans to help close your funding gap, especially at higher-cost colleges. For students on the edge between tiers, a little bump in credit score can make a big difference in the overall amount paid for education funding.
Here are some of the best things you can do to improve your credit score:
- Make all your payments on time. A positive payment history can help you boost your credit score. A single missed payment can damage an otherwise great credit score.
- Consider using small amounts of debt. To build a credit history, you need to use credit. A few small purchases on a credit card, paid off each month before interest charges kick in, can improve your credit score. An auto loan in your name can also help. Just be careful. You want to keep debts small and pay them off quickly.
- If you do have debt, pay it down. Pay off as much debt as you can in order to reduce your credit utilization.
Once you improve your credit score, maintain it by following good financial principles and avoiding debt as much as possible.
Your credit score is a huge part of your private student loan rates. Any time you borrow from private lenders, they want to know where you stand with credit. The more you work to improve your score, the more money you’ll save throughout your financial life.