Last month, the Federal Reserve announced an interest rate hike for the first time in a decade. And December’s decision may be the first of many such hikes. San Francisco Federal Reserve President John Williams anticipates as many as five rate hikes this year – which would put the target federal funds rate at 1.4 percent. However, Fed Chair Janet Yellen herself has set expectations for “a quite gradual pace over the next few years.”
Does the Fed interest rate hike affect you as a borrower?
For many of you, the answer is no… not a whit. If you hold a fixed-interest rate loan, whether it’s a federally guaranteed loan or not, nothing you read in the news about interest rates is going to affect your payment to the student loan servicer.
At any rate, viewed from a historical perspective, the federal funds rate is just above all-time historical lows. It’s going to take several incremental interest rate hikes to move actual interest rates on smaller or shorter-term loans enough to cripple most borrowers.
Direct Federal Loans Disbursed After July 1, 2006 and Federal Loans Since 2010
When a lender lets you borrow money at a fixed rate – whether it’s for a car loan, a home mortgage or an education loan, the lender is taking on the risk that interest rates may increase in the future. So if you have a fixed rate loan, any interest rate increases – whether it’s the federal funds rate, or the yield on 10-year Treasury bonds, or average home mortgage interest rates or anything in between – are the lender’s problem. Not yours.
That’s going to apply to any student loan borrowers who took out their loans since July of 2006. All loans since then have been fixed rate, not variable rate loans.
Federal Loans Disbursed June 30, 2006 and Earlier
For those of you with older federally-guaranteed student loan balances, you could see some interest rate increases. This is going to mean it may take longer to pay off your loan at your current payment level, or it could mean your payment required to pay off the loan on schedule will increase slightly.
Rates for these loans are calculated based on the 91-Day treasury auction on the last Monday in May and are effective as of June. So any changes in your interest rates won’t become effective until summer.
For details on variable loans by disbursement date, click here.
Loans from Private Lenders
If you have a private loan, naturally, the terms on your promissory note will govern what happens in the event of an interest rate increase. Your note should explain how the rate is calculated and when that calculation occurs. However, it’s quite common for private lenders to benchmark their interest rates off of the LIBOR, or London Interbank Offered Rate. For example, your loan could have an interest rate of LIBOR + x percent, calculated annually as of a certain date. Each loan is different, of course. But when the Federal Reserve hikes the federal funds rate, the LIBOR won’t be far behind.
Looked at more broadly, though, interest rate increases are generally very good for net lenders and investors, and bad for net borrowers. When the Federal Reserve hikes short-term interest rates via manipulating the federal funds rate, investor returns on safe savings increase. CD and money market rates tend to increase. Inflation – a friend to debtors and a mortal enemy to creditors – tends to ease, benefiting lenders over borrowers. Corporations get better returns on investments, making it easier for them to increase dividends in order to attract capital.
As interest rates increase, it makes more and more sense for borrowers to pay down debt faster so they can begin investing money, rather than paying off debt.
Considerations for Employers
A rising interest rate environment also makes student loan repayment assistance a more valuable benefit for employees. When employers help younger workers who struggle with student loans pay them off, they can maximize participation in their company 401(k) that much sooner. This helps strengthen the bond between employee and employer in a very real way: Onboarding employees into the company 401(k) plan means matching contributions are subject to the plan’s vesting requirements – which helps reduce turnover and increase retention.