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Market-Based Student Loan Rates: What They Are and What They Mean for Borrowers

Jul 31, 2013 Jennifer Williamson, Distance Education.org Columnist | 0 Comments

Federal student loan interest rates are a highly politicized issue. Last year, the federal interest rate on student loans was set to rise from 3.4% to 6.8%--and, under considerable pressure, politicians pushed that increase off for a year. Now, the interest rate is due to increase again—and politicians are discussing ways they can diffuse the situation more permanently.

One of the solutions being proposed—on both the right and the left—is a student loan rate based on market forces rather than one set by the government every year. Republicans are proposing one plan that relies on market-based repayment; President Obama has proposed a different student loan overhaul that also relies on it. While the President has promised to veto the Republican plan, it’s likely that some form of market-based repayment may become the law of the land anyway.

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This could have the effect of de-politicizing the issue, as student loan interest rates would theoretically not become such a hot-button issue once a year when the interest rate is due to rise again. But it has its drawbacks as well—and could become a political issue for other reasons.

With market-based repayment, interest rates for all newly-originated student loans from traditional and accredited online schools would be established every year based on the yield for 10-year treasury notes. A ten-year treasury note is essentially an investment you make in the US government—the yield is the return on investment you get. Interest rates for most loans throughout the US are based on the yield for 10-year treasury notes.

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Under the President’s version of the plan, once your interest is set at the origination of the loan, it’s fixed. The Republicans’ plan includes variable-rate interest that adjusts every year in response to the 10-year treasury notes. Under both plans, the interest rate would rise slightly today if the government doesn’t raise the interest rate—instead of 3.4%, it would go up to around 4.75%. Go back to 2007, however, and a student loan made under those conditions would have a rate of approximately 8%--so your interest rate depends on when you were lucky (or unlucky) enough to graduate.

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The drawbacks for this plan are obvious—and many student advocacy groups are protesting. That’s because in most cases, market-based student loan interest rates mean higher costs for students, as well as possible vulnerability to higher interest rates if the country goes into a period of inflation. The benefit, of course, is lower costs and higher revenues for the government—and which side you come down on depends on which you give higher priority to.

Another thing to note is that, under both the Republican plan and President Obama’s most current proposal, there is no cap set on the interest rate for student borrowers. If the government set a limit on potential interest rates, it could result in better protections for students facing the unpredictabilities of the market. Some detractors, however, state that with Income-Based Repayment and other programs designed to reduce the student loan debt burden, a cap on interest rates is unnecessary.

Market-based student loan rates could be a better deal or a worse one, depending on the fine print—whether they’re fixed or variable, whether or not there’s an interest rate cap, and whether the money saved will go back to other programs that help students. But in general, they are likely to cost students more than keeping the federal interest rate at 3.4%. True, this might wind up costing the government less—but if the goal is helping students, market-based student loan rates may not be the best strategy.

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