Federal Student Loans – Still the Best Deal for Undergrads

Interest rates have increased noticeably over the past year, which means that Federal student loan interest rates will climb as well. When? By how much? Will the rate on this loan increase more in the future? Is there a better option for undergraduate students to borrow for college? These are all questions into which potential college students and their families should be looking.

First Up: Is There a Better Option?

Without burying the lead, let’s answer the last question first.

Federal student loan programs, though flawed, remain the best deal in town for undergraduate students because...

  • The government lends to students as a matter of public policy. Banks generally do not make loans to people without jobs and a demonstrated capacity to repay the money. Many, if not most, recent high school graduates fit this bill.
  • Nearly all students are eligible to borrow. The Department of Education’s (DoE) loan program offers virtually every high school graduate an opportunity to borrow with basically no questions asked.
  • Repayment terms remain very favorable. The current repayment terms for undergraduate student loans allow for the potential that some of the debt will be wiped out in the future. You won’t find a bank or other traditional lender willing to do that.

The Other Basic Questions

How much will the interest rate increase?

  • About one-half percentage point, from 4.99% to 5.50%, for students taking out new direct federal student loans in the fall, up from just 3.73% two years ago.

When will the interest rates increase?

  • July 1, 2023. Each year, the government sets the student loan interest rate that will be in effect from July 1 through the following June 30. The new rate of 5.50% will start for loans made beginning on July 1, 2023 through June 30, 2024.

Will the interest rate on this loan increase in the future?

  • No. The interest rate on this loan is fixed for the life of the loan. Should the student borrow again in the future, the interest rate on the new loan will also be fixed at a potentially different rate at the time the new loan is made. This means that students starting college in the fall could, in theory, graduate having four loans with four different fixed interest rates.

A Deeper Dive

The federal government recognized that graduating high school and college students would not be able to get a loan from a bank or traditional lender to pay for college. So, in 1965, they set up a program to ensure that students would have access to loans to better help them attend college.

This program for undergraduates, called the Federal Direct Loan Program, continues to possess many features, nuances, and highlights worth noting some 60 years later:

  • The U.S. Department of Education (DoE) is the lender. Depending on financial need, a student may be eligible for a Direct Subsidized Loan (DoE pays the interest for specific periods of time) or a Direct Unsubsidized Loan (student responsible for interest from the start).
  • Annual borrowing amounts are capped at $5,500 for freshmen, $6,500 for sophomores, and $7,500 for juniors and seniors who are categorized as Dependent students.
  • The interest rate is fixed for the life of the loan and becomes effective on July 1 each year for the next academic year.
  • DoE charges students an Origination Fee to get a loan.
  • The program requires borrowers to go through both Entrance and Exit Counseling to help students better understand the loan process and all its details, especially their obligations.
  • Students are not required to undergo a credit check before getting a loan.
  • There are currently 8 different repayment plans that student may choose from including some that offer loan forgiveness when certain conditions are met.

Details for Undergraduate Borrowers

Under the William D. Ford Federal Direct Loan Program (a.k.a. Direct Loans), there are four types of Direct Loans:

  • Direct Subsidized: for students
  • Direct Unsubsidized: for students
  • Direct PLUS: for parents
  • Direct Consolidation: for students or parents

To be eligible for a Direct Loan, borrowers must first file a FAFSA® form (“Free Application for Federal Student Aid”) for the academic year that begins the following year. Students seeking a federal loan for the academic year 2024-25, which begins in the summer of 2024, would need to file the FAFSA® using tax information from their 2022 tax returns. Presently, the DoE is making significant changes to the financial aid formula and plans to release the new FAFSA® form in December.

NOTE: Students must be U.S. citizens (or eligible noncitizens) and be enrolled or accepted for enrollment in an eligible degree or certificate program.

Subsidized vs. Unsubsidized Direct Loans

The DoE uses the FAFSA® to capture information about both the family and the student to help determine a student’s eligibility for a Direct Subsidized Loan. Subsidized loans are need-based and relieve students from the responsibility for interest that accumulates during the in-school, grace, and deferment periods.

Unsubsidized loans require students to either pay the interest during those periods or to capitalize the interest. Students who capitalize interest choose not to pay the interest due on the loan. Instead, they elect to add that amount of unpaid interest to the principal amount of the original loan.

Direct PLUS Loans

The federal government also established the Direct Plus Loan program through which loans are issued to parents of dependent undergraduate students (a.k.a. Parent Plus Loans) and to graduate and professional students (a.k.a. Grad PLUS Loans).

Unlike other Direct Loans, Parent Plus and Grad Plus Loans are credit-tested. Borrowers cannot have an Adverse Credit History as defined by the DoE. Borrowers can be denied a Plus Loan for several reasons including a prior student loan default or having balances greater than $2,085 that are at least 90 days past due, among other knock-out criteria.

Similar to loans for undergraduate students, PLUS Loans are made at a fixed rate that takes effect on July 1 and ends the following June 30, and also feature:

  • Fixed interest rate of 8.05% for Plus Loans made on or after July 1, 2023.
  • Origination Fee
  • Cap on the amount that may be borrowed. The Parent Plus Loan cap amount is the college’s cost of attendance (determined by the school) minus any other financial aid received.

Under the Parent Plus program, the parent is the sole borrower. Parents are unable to transfer the loan to the student in the future.

Private Credit Student Loans

Banks, credit unions, and others make Private Credit Loans to those who pass the lender’s credit tests. These credit tests are often very similar to requirements that lenders impose on borrowers for mortgages, personal loans, and automobile loans.

Often, dependent undergraduate students do not have the necessary established credit track record to pass a lender’s credit test, but they may still get a private loan. Nearly all Private loan lenders permit a co-signer to join the student as an obligor on a loan. In this way, the lenders consider the co-signer’s history and may extend a loan to the student and co-signer.

Important note: Both the student and the creditworthy co-signer are contractually obligated under the terms of the loan. If a student is unable to make payments, the co-signer needs to make the payment or they, too, will be reported as delinquent to the credit bureaus.

Many lenders also offer a co-signer release feature that permits the non-student co-signer to be removed from the loan once a student meets tests established by the lender.

Although each lender offers different features and different rates, the following are generally found in private loan programs:

  • Fixed or variable rate loans with an interest rate that is dependent on the creditworthy borrower’s credit profile
  • Rarely charge an Origination Fee
  • Varying repayment periods, often between 7 and 15 years
  • Maximum borrowing amount equal to the cost of attendance (minus other financial aid)
  • Do NOT offer the same flexible repayment terms offered under the Federal Direct Loan Program

The Last Word

Undergraduate students have several options from which to choose the best loan to help them pay for college. The Federal Direct Program is designed to give students a limited amount of money to pay for college at a fixed rate of interest with favorable repayment terms. Other lenders offer private loans, which may supplement or be a substitute for Federal Direct Loans.

Families should understand the terms and conditions for each loan option and choose the loan which offers an optimal combination of terms and conditions for the student or parent borrower. For most families, however, the Federal Direct Program offers the combination of student-favorable specifics that works the best.

For more college financial planning measures, please visit https://www.scstudentloan.org/resources