How do the Federal Interest Rate Cuts Affect My Student Loans?

Yesterday we discussed whether the recent action by the Federal Reserve to cut interest rates represents an opportunity for homebuyers to save money by refinancing their homes. Today, we will discuss what the rate cuts mean to your student loans. Unfortunately, after doing some research, we have found that how banks determine the rate as to which they will lend you money for school varies from financial institutions and different lending products. In addition, many other factors are used to help banks set your rates like co-signers, credit history, variable and fixed products, and percentage of origination fee (a percentage of the total amount of the loan). So, stay with us as we plow through the nontransparent world of student loan lending.

What Number do Banks Use to Set Their Rates?
Unlike home loans – where you have a sense of what your interest rate will be by easily checking what the national average is for products like a 30-year fixed loan – student loans use different benchmarks to base their lending. We will discuss three of the main benchmarks used that will hopefully help you get a sense as to whether refinancing your student loans is the right thing for you or not.

1) Cost of Funds Index (COFI)
Currently, my private variable student loan rates are based off the COFI. The COFI is a regional average of interest expenses incurred by financial institutions that is used to calculate variable rate loans. To our knowledge, the COFI rate is a private calculation between banks and is not available to the public. Most lenders readjust your rate quarterly (every three months) based off this average. Most importantly, the COFI is not directly linked to the federal funds rate, which means the index does not move in the same direction as the recent rate cuts. In fact, since January 1, my student loan rates have actually increased. You can easily find out how your student loan rates are set by calling your lender and asking, it worked for me.

2) London Interbank Offered Rate (LIBOR)
Many lenders will use this rate if you decide to consolidate your private student loans with a variable rate product. The LIBOR rate is the interest rate the most credit-worthy banks around the world charge each other for loans. The rate fluctuates throughout the day based on the market, similar to stocks. Most Student loan lenders that set their rates using LIBOR will readjust their rates quarterly, based on the LIBOR rate + an additional percentage depending on factors like if you have a co-signer, how big of a origination fee you choose etc. For example, if I were to consolidate my student loans now my rate would be based of the LIBOR Rate from the start of the new quarter (January 1) which was at 5.12% + 3.14%(call your lender to ask what this additional amount will be) for an interest rate of 8.26%. It is important to remember that the LIBOR rate moves independently of the federal funds rate.

3) Prime Rate
The prime rate is usually about 300 basis points (or 3 percentage points) above the federal funds rate, which again is the rate that has recently been cut. Some student loan lenders and most credit card companies will use this rate + an additional percentage (based on the same factors listed above) to determine the rate as to which they will lend to you. Currently the Prime rate is around 6% and because this rate runs in sync with the federal funds rate, it is very easy to track. A consolidation that uses the Prime rate will likely be your cheapest current option, given the recent cuts.

What Does All of This Mean, Should I Consolidate My Private Student Loans?

We feel that if your rate is around 7-8% for you current private student loans, you will have a hard time finding a better rate. For those of you with decent credit histories and student loan rates well above 8%, it will not hurt to shop around a little. Keep in mind the different ways banks set your rates as described above, to help give you a sense of how your rates will fluctuate given the economy in the future.

Remember, the lowest rates generally will come with requirements of a co-signer, in addition to an origination fee. Most lenders will only allow you to consolidate your private loans with them once, but you can always use a different lender to consolidate in the future. Also, keep in mind when you consolidate, your loan term with some products will reset you to an additional 20 years. Therefore, if you have been paying your loans for 5 years and you consolidate, you will take the balance you currently have and stretch it out for another 20 years, meaning more interest payments. Just like home loans, don’t be afraid to ask about a fixed rate, generally you will be able to get a fixed rate of about 8.4% with a 1% origination fee and a peace of mind knowing your monthly payments will never change.

Lastly, before you say yes to a consolidation, do the math to determine the origination fee you will have to pay is less than the savings you will acquire with the lower rate. To figure this, take the origination fee minus the yearly amount you will save in monthly payments (click here for a loan repayment calculator) to ensure you will be saving more with the lower rate than you will be paying in fees to obtain the loan. $

Bush Administration’s Next Rescue Plan: Project Lifeline

As we all know by now, this country is in a rapidly increasing downward spiral in real estate, credit and mortgage lending. About a week after Bush released the economic stimulus plan, he and six large mortgage lenders unveiled a plan to come to the rescue of a majority of foreclosing families. The question is, how will this plan work out? Will it be effective? Will it turn our economy around? (Image credit to Rick LaForce)

How Bad Is It?
It seems difficult to fathom the severity of this drop in value across the board. Some refer to it as nothing but a “slump” or a “correction,” while others think of it as a “free fall” and a recession. Both have arguments have valid points. One the one hand, we can say that we have seen this sort of behavior before. It happened in the 70s as well as the 90s. In the early 2000s we saw a major rush into real estate that some say we are paying for now. The other side of this coin however is much more negative. Depending on who you talk to, we are headed straight for a recession (which is defined in macroeconomics as a decline in the nations Gross Domestic Product or negative economic growth for more that two quarters, or six month). Basically it means that we, as Americans, are not spending as much as we should be and demand dwindles, regardless of whether prices move up or down. A famous news paper columnist, Sydney J. Harris, is quoted as saying “A recession is when your neighbor loses his job; a depression is where you lose yours.” Personally, I have not noticed any reports, at the time of this writing, of an over all, wide spread loss in jobs. If you find differently, feel free to leave a comment and weigh in.

Little Help?
So what is the government’s reaction to this? Initially we saw the Federal Reserve lower the prime rate. Then they lowered it again. And again. They have continued to do this until the global markets began to take notice and start to fall. Then they cut it some more. The rate that it is at now has not been this low in a number of years. Not as low as what Alan Greenspan had in 2001, but still pretty darn low. What does this percentage rate mean? Basically it boils down to the interest rate at which one bank can borrow money from another. A lower rate means that more money is easier to borrow, but when it raises, the lending bank will make more money. Easy enough right? Right. But what does this mean for you?

What Does That Rate Mean, Anyway?
It means that the banks are getting cheaper money in order to turn around and lend it you, the home buyer. The theory behind this is that you will then go out and buy a house and that bank will make more money in the long run, if at all, since you might have kept right on renting. You will hear a good number of people saying that there are going to refinance now, since rates are lower. There are pros and cons to this that we will get into later, but for now, lets move forward with the big picture.

With this background we are better able to understand what the governments actions are attempting to do: pump life back into the country’s economy. After the rate cuts, Bush decided that best way to move more cash would be to directly inject it by putting it squarely in the wallet of the common citizen. We discuss elsewhere as to what we think you should do with it. As a side note, the tally for the amount of money being milked out was just about $150 billion dollars and there was a motion to add a another measly $40 billion so that the elderly and military vets could also participate. This barely passed at the 11th hour. How nice of them.

Beginning of the End or Just the Beginning?
Now we are the latest step in the governments’ intervention. Project Lifleline. This turns out to be a simple freeze on the time required to allow those families who are facing foreclosure, to renegotiate with their lender and get some time to get their finances in order. Those homeowners that are late by 90 days or more are the main targets of this resolution; however, homeowners in bankruptcy will not be eligible. Investment properties and vacant homes are also not included. The focus is valiantly centered on those that actually live in the troubled home. It makes more sense to save these first, as they are more able to pay, not to mention the money is much more guaranteed. Members of this program are Countrywide, JP Morgan, Washington Mutual and Wells Fargo.

There are naysayers (of course!) that believe that this is simply the beginning and this is a fruitless effort. Will the changes that these lenders are proposing be enough to put the brakes on this drop? It will be interesting to see where we can go from here. It also leads to a whole other discussion on investing. Have you taken a good look at the financial market lately? $