What drives the interest rates of federal student loans? The answer may surprise you. The rate, which changes each year, depends on the decisions of many people around the world: bankers in Europe, the Chinese government, Arab sheikhs and even Japanese housewives.1
In 2013, Congress and the president changed student loan regulations to allow the global financial markets to set the federally subsidized rate for direct subsidized and unsubsidized loans.2 Before that, Congress set the rate by law. After years of political wrangling over the best policy, the government decided to let the free market determine the rate. In particular, the rate is tied to something called the 10-year U.S. Treasury note.
A note is a kind of bond and is simply a promise to borrow money today in exchange for giving it back at a later time, plus some interest. Our government needs to borrow money for lots of things: roads, defense, education, healthcare, etc. The money it borrows for 10 years is called the 10-year U.S. Treasury note. And now, the interest it repays on those bonds sets your student loan rate.
Let's follow the money. Let's say the U.S. government borrowed from a Japanese housewife in 2014 and promised to pay her 2.6% interest for a 10-year note. Our government then turned around and loaned that money to students at 4.7%. (The government adds in about 2% for itself.) In later years, if the government has to pay more to borrow money, then it will pass that increase along to students. If it pays less to borrow, then rates will go down.
So the big question for students each year is how high the rate on the 10-year note will be. There are a lot of factors, most of which no one has much control over. Part of the answer is supply, meaning how much the government must borrow. We can make a pretty good guess about that. The hard part is figuring out how much people, governments and firms will demand these 10-year notes.
Foreign countries demand about one-third of U.S. debt. We hear a lot in the news about China, which holds about 8% of our debt, but Japan isn't far behind, at 7%. And tiny Belgium is the third-largest owner, at 2%.3 Since they're responsible for such a significant portion of our debt, foreign countries have a lot of influence on federal student loan rates because they can easily stop buying U.S. bonds.
Curiously, the largest holder of U.S. government bonds is actually the U.S. government itself. It owns 40% of its own debt. In other words, our government borrows from itself. The rest of the debt owners are large commercial banks, individuals, and multinational firms.
The Congressional Budget Office (CBO) makes its best guess at how much these diverse bondholders will demand in interest in the future. Back in 2013, when the student loan law was changed, the CBO thought rates would almost double by 2015.4 They were wrong. Rates actually went down, which is good news for student borrowers.
Where does all this leave students? The fact is that students are plugged into the global financial system whether they know it or not. The rates of their federal student loans will ride the ups and downs of the international markets. For now, rates are at historic lows, and that's a good thing for students.
1Japanese Housewives, http://www.investopedia.com/terms/j/japanese-housewives.asp, retrieved January 12, 2015.
2H.R.1911 — 113th Congress, https://www.congress.gov/bill/113th-congress/house-bill/1911, retrieved January 12, 2015.
3Who Holds Our Debt?, http://www.factcheck.org/2013/11/who-holds-our-debt/, retrieved January 12, 2015.
4How Different Future Interest Rates Would Affect Budget Deficits, http://www.cbo.gov/publication/44024, retrieved January 12, 2015.