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The way student loan interest rates are assigned raises a red flag on the system

Published by Business Insider on Thu, 24 Sep 2015

Since 2010, all federal student loans have been issued by the Department of Education at fixedinterest rates. The rate you get depends on the type of loan you take out, and the differences inthe rates at first glance are counterintuitive.For undergraduate education, the rate is currently 4.29%. For graduate education, if you areborrowing for yourself, the rate rises to 5.84% for the first $29,000 you borrow annually. If youneed more money for school, or your parents are borrowing to help you pay for school, the raterises again to 6.84% through the PLUS loan product. These rates are determined by adding afixed charge to the 10-year Treasury note each May for the following July 1 - June 30 period.Additionally, PLUS loans carry an onerous 4.272% origination fee thats subtracted from thedisbursed amount, compared to the 1.068% origination fee on undergraduate loans. All in, thismeans that graduate students or parent borrowers will pay an additional $3,330 over a standard10 year horizon to fund $20,000 in education expenses with PLUS loans.The differences in rates and fees brings up important points about the system worth exploring.Though the rationale for the rate difference is not articulated anywhere in the Office of FinancialAids materials, its clear that higher cost graduate loans and loans to parents (almost alwaysmore creditworthy than their children who are just starting out) are pegged at higher rates tosubsidize direct undergraduate lending. Student loan default rates currently stand at 14%, andthe vast majority of these defaults occur at the undergraduate level.In the private market, a stronger credit profile will yield a lower interest rate, not to mention thatmost private lenders do not charge origination fees for student loans. This discrepancy iscausing many borrowers to seek private options for student loans, or to refinance their federalstudent loans at a lower interest rate once they have graduated.Instead of having the desired effect of providing reliable income to cover riskier undergraduatelending, the best borrowers end up fleeing the system and cause the overall portfolio to becomeriskier. Though not the biggest student loan issue facing us today, the interest rate structure isindicative of a system that was cobbled together and not sufficiently evaluated before beinglaunched in the wild. Its a $100 billion annual and $1.1 trillion total experiment that is troublinglyslapdash and full of unintended consequences.SEE ALSO:There's a big problem with the government's offer to 'forgive' your mountain of student-loan debtJoin the conversation about this story
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