Paying for college has always been a challenge but this year may be the worst ever. To top off a miserably difficult financial aid season, interest rates on Federal Direct Loans for students and parents are set to increase, a lot.
This article will tell you why the interest rates are going up, offer some strategies to borrow at the least possible cost, and talk about private loans as a possible alternative to the Federal PLUS Loans.
Editor’s note: This article was originally contributed to The College Investor and published on May 16, 2024.
First, the Basics
Each year, the Department of Education’s Federal Direct Loan Program lends more than 90% of all the money to undergraduate and graduate students, and parents borrow to pay for college. This article focuses primarily on loans for dependent undergraduates and their parents. The Federal Direct Loan program offers students the best terms to borrow for college. That may not be the case for parents.
To be eligible for a federal student or parent loan, students must file a FAFSA® form.
- All undergraduates are eligible for a Federal Direct student loan regardless of their, or their parents’, income or assets.
- Parents who do not have “Adverse Credit” are eligible for a Federal PLUS Loan.
All other education loans are called private loans (a.k.a. private credit loans) which are made by any entity that is not the federal government. Private lenders include states (through state agencies or special not-for-profits), colleges, banks, credit unions, or other financial services firms. Each lender has its own respective loan application, criteria to determine if they will lend to you (a.k.a. your “creditworthiness”), and loan options with interest rates based on your creditworthiness.
Why Are Interest Rates on Federal Loans Increasing?
All loans made under the Federal Direct Loan Program are fixed rate loans, which means that the rate will not increase or decrease over the life of the loan.
The fixed rate for Direct Loans changes on July 1st each year and is in effect for all federal loans made from July 1st through June 30th of the next year. For loans made between July 1, 2024 and June 30, 2025, the undergraduate Direct Loan rate is 6.53%. The PLUS loan rate is 9.08%.
Direct Loan interest rates are set by a formula which requires the U.S. Department of Education to add on 2.05% for undergraduate Direct Loans and 4.60% for PLUS Loans to the yield on 10-Year Treasury Note auctioned in May each year. On May 8, 2024, the 10-Year Treasury Note auctioned for 4.48% resulting in the updated interest rates.
This year’s 10-Year Treasury Auction result was 1.03% greater than last year’s auction which means higher interest rates for students and parents.
Direct Loan Limits
Students determined to have financial need are offered Subsidized Direct Loans, which do not accrue interest until the start of the repayment period, usually six months after separating from school. The Direct Loan Program also makes Unsubsidized Loans which require borrowers to either pay interest while they are in-school or add the accruing interest to the initial amount borrowed.
The amount students can borrow is limited by their year of study:
- 1st year students: up to $5,500 with no more than $3,500 subsidized
- 2nd year students: up to $6,500 with no more than $4,500 subsidized
- 3rd year and beyond: up to $7,500 with no more than $5,500 subsidized
Dependent undergraduates are eligible to borrow no more than $31,000, with no more than $23,000 of subsidized loans.
Parents may borrow PLUS loans up to the cost of attendance as certified by the college.
Strategies for Minimizing Borrowing Costs
In addition to appealing to the college for more grants and scholarships and/or having a student work during school to reduce the amount of debt, families should:
- Borrow as little as possible. The first and most important question people ask: how much should we borrow? The answer is always the same: as little as possible. But that’s not realistically helpful, so here’s a rule of thumb upon which most experts agree: students should not borrow more than their projected first-year starting salary. Although a difficult and emotional decision, if a student needs to borrow significantly more than their projected starting salary, finding a less expensive school or taking a gap year to save some money may be a smart choice.
- Pay interest while the student is in-school. For Unsubsidized Direct Loans, paying interest in-school means that the student will graduate with the exact amount they signed up for. If interest is not paid in-school, it is added to the original amount borrowed (this is called capitalization). At graduation, the student will owe the original amount borrowed plus all the interest that was not paid. They will then pay interest on the new higher balance.
- Find scholarships to reduce the amount to be borrowed. Use this free scholarship search with approximately 6,000 scholarships to find money that does not have to be repaid.
- Use a tuition payment plan. Payment plans generally charge a one-time fee to pay some of the college bill. For example, a family may realize that they can use money from their jobs to pay some of the college bill each month. Let’s assume the family can afford to pay $100 per month, so they elect to use a payment plan that permits them to pay $100 per month for 10 months. The company pays the college $1,000 and the family makes the $100 monthly payments to the tuition payment plan company. This can be a handy way to use current income to reduce student loans.
- Compare Private and PLUS loans. Check to see if a private loan may be less expensive and more attractive than the Federal PLUS Loan.
- a. Understand the full cost. In addition to an interest rate of 9.03%, PLUS loans have an up-front origination fee of 4.23%. Unlike private lenders, who are required to disclose the APR (Annual Percentage Rate) on a loan, the Department of Education is not required to disclose the APR, which for PLUS loans is greater than the interest rate due to the up-front fee. Generally, private lenders do not charge up-front fees.
- b. Know who is the borrower. PLUS loans are made to parents – there is no way to transfer it to the student once it is made. Private lenders permit a student to apply with a co-signer (usually a parent) and often offer a “co-signer release” that stipulates the parents can be dropped from the loan when certain conditions are met. Co-signer releases are not available for PLUS loans.
Note that the word “generally” is used throughout. Check lenders’ web sites to get the specifics of each private student loan offering.
Other Private Student Loan Considerations
The Family Picture: As parents compare federal PLUS benefits versus the added cost and inability to be released from the loan, they should keep the big picture in mind. Some helpful questions to consider:
- Do we have other children who may need help?
- Will this be a one-time borrowing, or will we need to borrow at least this much each year the student is enrolled?
- Will the total we may need to borrow for college threaten OUR financial future or retirement? If so, a less expensive school may be the difficult, but necessary answer.
If you decide to get a parent loan, consider these factors when evaluating private loans:
- Private lender terms: Generally, private lenders offer loans with no origination fee, a 0.25% interest rate reduction if you auto-pay, a variety of repayment programs, fixed or variable rates based on credit score, and co-signer releases.
- Private lender interest rates: Generally, private lenders use the FICO or other credit score as a key in their underwriting criteria. Upon evaluating an application, they will decline to make a loan or offer one at an interest rate based on the applicant’s creditworthiness. Those with weaker credit may be offered a loan but with a higher interest rate.
- State-based lenders often offer lower interest rate loans. Generally, state-affiliated lenders fund their programs using tax-exempt bonds. Their lower borrowing costs result in lower interest rates for their customers. Many of these entities are members of The Education Finance Council. You can find their private student loan programs here.
This year, state affiliated lenders will likely offer loans with interest rates significantly lower than the 9.08% PLUS loan rate because of technical market conditions. Their current tax-exempt borrowing costs are significantly lower than the 10-Year Treasury rate of 4.48%. Many will be able to offer loans in the range of 6% to 7% to their top tier (FICO scores greater than 740) and many mid-tier (700 – 739) applicants. Lower credit tier borrowers (670 – 699) may also likely be offered loans below 9.08%.
Other lenders such as banks, credit unions and finance companies fund their loan programs in the taxable markets. Some will also likely offer loans to many borrowers at interest rates below the 9.08% PLUS rate.
Buyer Beware: Private lenders offer fixed and variable rate loans. Be careful with variable rate loans. The starting rate will increase and decrease over time. A variable rate loan which may be very affordable today can become a burden if interest rates rise. Be sure to know how often the interest rate resets (most are monthly) and what the maximum interest rate is that the lender can charge (often the state usury rate, which can be very high). The phrase “know before you owe” is particularly true for variable rate loans.
When carefully considered, student loans fill an important piece of a family’s plan to pay for college. Smart borrowers are sure to understand the terms and conditions well before the e-signature is collected. My College Corner hopes you keep one of our favorite phrases in mind: student loans should be the last resort, not the first option to pay for college.