Federal Student Loan Interest Rates Expected to Rise Dramatically

This year, federal student loan borrowers can expect the interest rates on their loans to jump 30% or more come July 1, 2006, after the government completes its annual resetting of student loan rates.

Federal student loans (also called Stafford loans) are variable rate loans and the government resets the interest rate on those loans every July based on market interest rates. The benchmark interest rate used by the government, the 91-day Treasury bill rate, has risen approximately 30% since July 2005 and the Federal Reserve is expected to push market interest rates even higher between now and July 1.

One way students can avoid paying more on their loans starting July 1 is to consolidate under the Federal Student Loan Consolidation Program. In recent years, "borrowers have been able to shave thousands of dollars in interest from their loans by consolidating loans at record low rates," according to USA Today.* ( Read the USA Today article.)

By consolidating prior to July 1, 2006, students can lock in a single, historically-low fixed rate on their loans (currently as low as 4.75%, and the fixed rate can drop even lower to 3.5%, after taking into account additional benefits offered by many consolidation lenders).

Continuing Students Can Consolidate While Still In School

Students who will be in school beyond July 2006 can also take advantage of the Federal Student Loan Consolidation Program to lock in today's low rates, ahead of the July 1 rate hike.

Historically, students generally had to graduate before they could consolidate their loans under the federal program. However, in the past year the U.S. Department of Education has confirmed that continuing students are eligible to consolidate their loans while still in school. Congress is set to eliminate this "in-school" consolidation option for students starting July 1, 2006.

Just as with a typical consolidation loan, repayment on an "in-school" consolidation loan does not begin until after the borrower leaves school, but "in-school" consolidation does require the borrower to waive the six-month "grace period" following school, during which time no payments are required. As a result, the loans consolidated will enter immediate repayment, unless the borrower applies for a deferment or forbearance of the loan payments. During periods of deferment or forbearance the borrower is not required to make payments on the loan. During deferment, the federal government continues to pay the interest on the subsidized portion of the consolidation loan, while during forbearance interest accumulates on both the subsidized and unsubsidized portions of the consolidation loan.

Generally speaking, the practical effect of waiving the grace period is that the borrower will, unless granted a deferment, lose six months of government-subsidized interest payments on his or her subsidized federal loans.

Who Should Consider In-School Consolidation

You must have at least $7,500 in federal loans to consolidate, so most college freshmen and sophomores won't qualify for in-school consolidation.

In-school consolidation may, however, be a very attractive option for returning medical, law and b-school students with high loan balances. Consolidating now to lock in today's lower rates can result in thousands of dollars in interest savings over the life of the loans consolidated. For many graduate school borrowers this interest savings will far exceed even losing a full six month's worth of government interest subsidy during the foregone "grace period."

See if in-school consolidation is right for you through Vault's no-obligations loan consolidation service.

Ask Vault's Expert

Have questions? Please drop Vault's expert, Peter Wilkniss, a line at pwilkniss@vault.com. Peter holds a BA in Economics for the University of Virginia and a JD/MBA from Columbia (with tons of student loans!). He practiced law at Wachtell, Lipton, Rosen & Katz in New York, and held senior financial management positions on Wall Street, before helping start and run a student loan company.

*Consolidating student loans now will save on interest, USA Today, December 22, 2005, Online Edition.