Lately, we've seen lots of conversations in the media about the expected Federal Reserve interest rate increase. Nobody is sure when it is going to happen or how quickly it will go up, but experts seem to agree that interest rates will increase soon.
How will this affect my student loan interest rate?
To many of us, it wonâ€™t. If you already have a federal student loan or your private student loan has a fixed-interest rate, then this rate hike will have no effect on your interest rate. In a fixed interest loan, your interest rate is set. Your rate cannot be changed by your bank or the government, no matter what happens to interest rates in general.
If, however, your loan is from a private lender, then it is quite possible that you have a variable rate loan. If this is the case, then your interest rate is determined by market interest rates. This would mean that a change in global interest rates could increase or decrease the amount that you owe. Unfortunately, interest rates are so low at the moment that theyâ€™re more likely to rise than fall.
What is the â€œmarket interest rateâ€ and how does it relate to my interest rate?
Variable rates, also called floating or adjustable rates, are normally tied to a reference rate, also called a benchmark rate. Arguably the most influential benchmark for commercial loans is LIBOR, the London Interbank Offered Rate, which is the industry standard for student loans. Normally, variable commercial loans, such as student loans, are calculated by adding percentage points to the benchmark rate. Therefore, as the benchmark goes up or down, so too does the interest rate on your variable student loan.
What is the Fed?
While the Fed does not have any direct control over LIBOR, it is able to influence any benchmark rate. But in order to understand how the Fed does this, it is important to understand exactly what the Fed is.
The Federal Reserve System is the central banking system of the United States. It is tasked with helping the United States government regulate the economy by deciding U.S. monetary policy. This means that it has the power to manipulate the supply of money in circulation, in this case the dollar, in order to promote economic growth, fuel employment, and control inflation. Recently, it has also taken on the responsibility of regulating the banking industry and ensuring that Americaâ€™s financial system remains stable.
In 2008, the Fed attempted to stimulate economic growth by increasing the supply of money in the U.S. economy, a policy called quantitative easing. It did this by printing money and buying Treasury bonds and mortgage-backed securities â€“ essentially pumping more money into the economy. Interest rates can be thought of as the price of money and are subject to the same forces of supply and demand as any price. Therefore, when the Fed created more money, this drove down the price of money, i.e. decreased interest rates. This promoted borrowing and discouraged saving, therefore encouraging economic growth. Now that the economy is doing well, the Fed would like to increase interest rates again, because low interest rates can lead to risky bubbles and inflation. The first thing the Fed did was to stop its policy of quantitative easing, but this will only have an effect in the long term.
In order to influence short-term interest rates, the Fedâ€™s main tool is the federal funds rate. By U.S. law, banks are required to leave a percentage of their reserves with the Fed overnight. The federal funds rate is the rate at which banks borrow from each other overnight from these reserves. Why do banks need to borrow from each other? Because they lend out money to people like you and me, in credit cards, mortgages, student loans, etc., and get it back when people deposit money. Sometimes, these balances do not add up, and they need to borrow small amounts of cash from these federal funds to cover their short-term costs. The Fed has complete control over the rate at which banks can do this. By controlling the federal funds rate, the Fed has the power to raise or lower the costs of borrowing for these big banks and in doing so, can manipulate their interest rates.
But how does this affect LIBOR?
Now, the Fed isnâ€™t the only place that banks borrow from; they can borrow from each other. Large banks can also turn to foreign banks with large U.S. dollar reserves, also called eurodollars. LIBOR is the average amount that large banks say that other large banks would charge them for these eurodollar loans. Hence, when the federal funds rate changes, LIBOR is quick to follow, because eurodollars are essentially a replacement for federal funds. If the prices diverge too much, as they did in 2008, then the forces of supply and demand quickly mean the two interest rates converge. Therefore, when the Fed finally does decide to increase interest rates, your variable interest rate will quickly follow.
The good news is that the Fed is likely to increase rates at a very slow pace. In 1994 Federal rates increased several times in that year, ending with a massive 75 point hike. This took consumers and banks completely by surprise. This time, however, the Fed is expected to move slowly, and have been giving plenty of warning. Although we cannot be sure how much interest rates will increase by, we can be fairly confident that it will happen gradually.