The Federal Student Loan Interest Rate - What It Is & How It Works

As the first person in my family to attend college in the United States, right after completing high school in the Caribbean, navigating Federal financial aid that offered me a menu of mostly student loans, was very confusing.

After signing up for Perkins, subsidized and subsidized Stafford student loans, I had no idea how interest rates were set, or that the loans were issued the same calendar year could have different fixed interest rates.

It was only after I transferred from my private university (to get off of the path to $100,000 in student loan debt) and I started to educate myself about student loans, was when I realized that the interest rate on the student loans I took out every semester, could vary over the course of my college career.

By the time I graduated from college in 2007, the annual interest rates of my Federal student loans varied from 2.77% to 6.8%, depending on which semester each loan was initiated.

In this post, I’ll go over how the annual interest rates for Federal student loans work.

Federal Student Loan Interest - What It Is 

First, understand that the interest rate for a Federal student loan is defined as the money charged by the lender (i.e. the U.S. Department of Education in the case Federal student loans ) in exchange for borrowing money expressed as a percentage. The interest rate for each Federal student loan is fixed for its lifetime.

Federal Student Loan Interest - Who Sets The Rate

The interest on Federal Direct subsidized, unsubsidized and Plus student loans are set by the U.S. Congress at fixed rates over the life of each loan. As prescribed by the Higher Education Act of 1965, new interest rates for Federal Direct student loans are established July 1st of each calendar year.

The formula for those interest rate is as follows:

Federal Student Loan Interest Formula:
10-year Treasury Note Index + Add On Amount = Student Loan Interest Rate

Where: The 10- Year Treasury Note Index: is the high yield of the 10-year Treasury note at the final auction held prior to the June 1 preceding the July 1 of the year the new student loan rate will be effective. This index is announced on the US. Department of Education’s Office of Federal Student Aid Information for Financial Aid Professionals website

Note: A Perkins student loan has an annual interest rate 5% regardless of the loan initiation date and is not dependent on the high yield of the 10-year Treasury note. Perkins Loans are backed by the U.S. Department of Education program where a student can borrow directly from their college and university.

Congress also defined what the "Add On Amount" would be, based on the type of Federal student loan and who is borrowing the funds (i.e. an undergraduate student, a graduate or professional student or a parent). These Add On Amounts are summarized in the table below.

ADD ON AMOUNTS FOR FEDERAL DIRECT STUDENT LOAN INTEREST RATES

LOAN TYPE

  • Subsidized & Unsubsidized
  • Unsubsidized Loan
  •  Plus Loan          

BORROWER

  • Undergraduate Student
  • Graduate Student
  • Parent, Graduate or Professional Student

ADD ON

  • 2.05 %    
  • 3.60 %      
  • 4.60 %   

In summary:

  • The rate is set by Congress as prescribed by the Higher Education Act
  • The interest rate is calculated using a formula based on the 10-Year Treasury Note Index and an Add On Amount
  • The 10-Year Treasury Note Index can change every year
  • The Add On Amount depends on the type of student loan and who is borrowing the funds

This is how the student loan interest rate is set, using all these variables.

How Federal Student Loan Annual Interest Rates Are Set & Can Change Every YearClick To Tweet

Federal Student Loan Interest Rate - What Are The Current Rates

The 10- Year Treasury Note Index used to set Federal student loan interest rates effective as of July 1, 2017 was  2.40% (Source: ifap.ed.gov/eannouncements).

Based on the Federal Interest Rate Formula, the interest rate for Federal student loans disbursed between July 1, 2017 through and June 30, 2018 can be easily calculated using the interest formula.

Federal Student Loan Interest Formula:
2.40% + Add On Amount = Student Loan Interest Rate

By plugging in the Add On Amounts, defined in the previous section, into the Federal student loan interest rate formula, the resulting fixed annual interest rates are presented in the table below.

FEDERAL STUDENT LOAN INTEREST RATES       (For Loans Issued between July 1, 2017 & June 30, 2018)

LOAN TYPE

  • Subsidized & Unsubsidized
  • Unsubsidized Loan
  •  Plus Loan          

BORROWER

  • Undergraduate Student
  • Graduate Student
  • Parent, Graduate or Professional Student

INTEREST

  • 4.45 %    
  • 6.0%       
  • 7.0 %      

Federal Student Loan Interest - How The Change In Interest Rates  Affect You

When the Federal student loan interest rates change, they affect the cost of loans issued after July 1st of the year the change goes into effect. This means that any student loans issued prior to July 1st, won't change and will remain fixed, whether you are a current student or a long time graduate.

For current undergraduate, graduate and professional students or parents, planning to sign up for Federal student loans after a rate change, the new rates will apply only to those newly disbursed loans (between July 1, 2017 and June 30, 2018).

It's easy to understand how the fact that interest rates on Federal student loans that not only vary by the type of loan and who is doing the borrowing the money but also change from year, can cause so many student loan borrowers and parents to be confused about how much they can expect their student loans to cost them, after graduation.

Still, if you are a borrower, taking the time understand the debt you signed up for is essential to get rid of them, as soon as possible.


How much did you know about how Federal student loan interest rates are set?

I hope you found this breakdown useful

~ Melisa Boutin