Predicting student loan interest rates is like predicting the weather. If you want to know what tomorrow’s weather will be, look out the window today.
Accurately predicting student loan interest rates also requires an understanding of how student loan interest rates are set.
Predicting Interest Rates on Federal Student Loans
Federal student loan interest rates are fixed interest rates that are set each July 1 for loans disbursed July 1 to June 30.
The interest rate is based on the high yield of the last 10-Year Treasury Note auction in May, plus a margin. The margin adds 2.05 percentage points for undergraduate Federal Direct Stafford Loans, 3.6 percentage points for graduate Federal Direct Stafford Loans and 4.6 percentage points for Federal Direct PLUS loans.
To predict where the 10-Year Treasury Note auction high yield will be in May, consider the high yield from the most recent auction, in March.
There normally is not a lot of movement in the interest rates from March to May. Over the last decade, the change in the high yield for the 10-Year Treasury Note has been as low as a 28.9 bp decrease and as high as a 10.6 bp increase. (The unit bp is an abbreviation for basis point. A basis point is one one-hundredth of a percent, or 0.01%.)
A decrease is more common than an increase, occurring in 8 of the last 10 years. Interest rate changes are also influenced by market expectations concerning future interest rate cuts by the Federal Reserve Board. The Federal Reserve Board cut the Federal Funds Rate target by 50 bp to 1.0% to 1.25% on March 3, 2020.
The most recent 10-Year Treasury Note auction occurred on March 11, 2020, with a high yield of 0.849%, down from the 1.622% high yield from the February 12, 2020 auction.
If interest rates on federal student loans were to be based on the March auction high yield, as opposed to the upcoming May auction, the predicted interest rates for 2020-2021 would be 2.899% on undergraduate Federal Direct Stafford Loans, 4.449% on graduate Federal Direct Stafford Loans and 5.449% on Federal Direct PLUS Loans.
That’s 1.63% percentage points lower than the current 2019-2020 interest rates.
It does not quite set a new record. The record low for federal student loan interest rates was 2.875% in 2005.
Interest rates are volatile right now. If the Federal Reserve Board cuts interest rates even further, it could lead to even lower interest rates. It looks like the market pricing in 60% odds of a further 25 bp interest rate cut by the Federal Reserve Board. On the other hand, if the COVID-19 outbreak gets under control within the next two months, the interest rates could be higher than these predictions.
Predicting Interest Rates on Private Student Loans
Interest rates on private student loans are updated more frequently than federal student loans.
Interest rates on both variable and fixed-rate private student loans are pegged to the 1-month or 3-month LIBOR index or the Prime Lending Rate.
Most private student loans are pegged to the 1-month LIBOR index, meaning that interest rates on private student loans will reflect changes in prevailing interest rates within less than a month.
The 3-month LIBOR, on the other hand, is based on a 3-month moving average, so it will take up to three months to fully phase in interest rate changes.
How Can You Benefit from Interest Rate Changes?
Students and parents are unable to borrow future federal student loans early, as the interest rates are set based on the date the student loans are disbursed.
Older federal student loans cannot be refinanced as new federal loans to obtain a lower interest rate. A federal consolidation loan bases its interest rate on the weighted average of the interest rates on the loans included in the consolidation. This yields a new interest rate that more or less preserves the cost of the underlying loans.
Private student loans, on the other hand, react more quickly to interest rate changes than federal student loans.
You can refinance a fixed-rate private student loan to take advantage of new, lower interest rates.
There are no prepayment penalties on federal and private student loans, so nothing stops you from refinancing your private student loans to take advantage of the new interest rates.
You can refinance a federal loan into a private student loan to take advantage of lower interest rates. However, the interest rates on federal student loans are generally lower than the interest rates on private student loans. The main exception is Federal Direct PLUS loans, where a borrower with excellent credit may be able to qualify for a lower rate on a private student loan. However, when you refinance federal loans into a private student loan, you lose the superior benefits of federal loans, such as death and disability discharges, longer deferments and forbearances, income-driven repayment plans and any federal loan forgiveness options.