How the Fed impacts student loans

The Fed hiked interest rates by a quarter percentage point during its July 26 meeting, increasing the target rate to 5.25-5.5 percent. The rate hike followed a pause at the June 14 meeting when rates did not rise for the first time in 15 months.

If you borrow money to attend college, you will never feel any impact when the Federal Reserve adjusts interest rates. The majority of Americans with student loan debt have fixed interest rates, which means their monthly payments will remain constant during the duration of their loans. Federal loans almost always have a fixed interest rate.

However, borrowers with private student loans with variable interest rates will see changes any time the Federal Reserve raises or lowers rates. New borrowers will also see slightly higher rates across the board, although they may still be able to get a decent rate depending on their personal finances.

The Main Points

The interest rates on federal student loans are always flat. These rates are set on July 1 of each year for loans issued from July 1 to June 30 of the following year.

Federal student loan interest rates are set based on the previous May 10-year Treasury auction yield, plus a margin that varies based on the type of federal loan.

Borrowers with federal student loans will see no change when the Fed lowers interest rates.

Borrowers of variable rate student loans from private lenders may see interest rates change as the federal funds rate changes.

How is interest calculated on a student loan?

All student loans, whether federal or private, accrue interest at some point. However, the way interest is calculated depends on the type of loan you use, who the lender is and your rate type.

With federal student loans, Congress sets a flat rate of interest each academic year. Last spring, officials met to determine the cost of obtaining student loans between July 1, 2022, and June 30, 2023, as well as what to expect this season for the 2023-24 school year. See you again in the spring. The type of loan you get and when you borrow determines your interest rate, but the interest rate is the same for all borrowers, regardless of credit score or financial profile.

Private student lenders use the London Interbank Offered Rate (Libor) above the average market rate. Your interest rate is also affected by your credit score and whether you take a fixed or variable rate.

How does the Federal Reserve affect student loan interest rates?

Although the federal funds rate isn't the exact interest rate you'll be charged for credit, it does serve as a benchmark for the rates you'll get for things like auto loans or personal loans. Essentially, if the Federal Reserve raises or lowers the federal funds rate, the interest rates on those loans respond accordingly.

While the Fed doesn't have direct control over student loan interest rates, you can start to see them react in a similar way. That's because Congress ties interest rates to external market forces, specifically the 10-year US Treasury yield. The same factors that influence these returns also dictate the decision-making of Federal Reserve officials.

If you already have fixed-rate student loans, the Fed's decisions won't affect you at all. However, if you are taking out a new loan, your rate will reflect current trends.

If your student loan has a variable interest rate, you will notice that the feed rate changes often. When the Fed raises or lowers the cost of borrowing, your interest rate will likely respond. This could mean that you pay more or less interest over time, depending on how the Fed rate changes.

With the Fed raising interest rates ten times since March 2022, borrowers with variable student loans can expect interest rates to rise slightly. Federal student loan interest rates for the 2023-24 academic year may also be higher than in prior years.

How to respond to Fed interest rate changes

In an environment of volatile interest rates, your best next steps may vary from doing nothing to refinancing your loans. Here are some tips to guide you based on the type of student loans you have:

If you have federal student loans: If you have federal student loans, higher interest rates will not affect your loan payments or the interest you pay. It is best to stick to your existing loans.

If you have a fixed-rate private student loan: If you have a fixed-rate private student loan, the federal changes won't affect you, because you have a fixed interest rate throughout your repayment period. However, you can always check with your lenders to see if you can refinance a new loan at a lower fixed rate.

If you have a variable rate private student loan: If you have a variable rate private student loan, you may see your monthly payment and monthly interest fee change based on market conditions. If a rate change increases your monthly payment, shop around to make sure you get the best rate available based on your credit score and other factors. If rates are expected to rise further, you can choose to refinance into a fixed rate loan.

When should you refinance?

Regardless of whether you have federal or private student loans, you have the option of refinancing your loans to get a better deal. Refinancing is taking out a new loan with a new interest rate and new payment terms, paying off your old loans and then making one payment on your new loan.

You should refinance your student loans if:

You have a strong credit score. Since you are getting a loan from a private lender, your credit score and credit history will determine your new interest rate. If you don't have a better or worse credit score, your interest rate will be higher than someone with a better score.

Have private student loans. Federal student loans have a number of protections, such as deferral, forbearance, and income-based repayment plans. They go away when refinancing. If you already have private student loans, you won't miss out on these benefits.

You will get a lower interest rate. If you have a high interest rate -- whether it's fixed or variable -- a large portion of your monthly payments will be diverted to interest rather than your principal balance. If you can secure a lower interest rate, you will get a lower monthly payment. If you're struggling to make payments right now, this may be your biggest refinancing commitment.

You have loans with variable interest rates. Student loans may become more expensive in the coming years if the Federal Reserve raises interest rates. You can choose to refinance into a fixed rate loan now to secure a cheaper loan.

Next Steps

The Fed's decisions will not necessarily affect your student loans. However, if you have a variable-rate student loan, or if you're hoping to get a new student loan, it's worth keeping an eye on how the federal funds rate changes. Timing your student loan correctly can help you save money on interest over time.