How Much Difference Do Interest Rates Make On Student Loans?

Recently our home province of Manitoba dropped the rate of interest the charge on student loans to “prime”.  This was sort of dismissed by a lot of students we talked to as irrelevant, but the truth is that it is a major favour for us young bloods (sorry, I’ve been watching the Uncle Drew Pepsi basketball commercials too much).  I’m pretty certain that this dismissive reaction is mainly due to the fact that most students just don’t really care to know how interest rates work and why they’re important.  If you’re not too sure what “prime” means, it refers to the prime lending rate, and it is the rate at which the bank charges interest to its best or “prime” customers.  Right now in Canada for example, the prime rate is 3% and it has been for a while.  You will often here loans referred to as, “Prime + __%” and whichever number goes in that space can make a pretty big difference going forward.

Let’s take a look at a few hypothetical scenarios just to give you some idea of how many dolla bills ya’ll be savin if you’re province gives out student loans at prime:

Scenario A: The federal government charges a rate of prime + 2.5% on the federal portion of your student loan, so we’ll use that as a comparison point in our first example (even though we’re talking about a provincial rate).

Joe Degree graduates with an average amount of student debt these days: $27,000.  He goes to his bank and works out a payment plan that will take place over the next 10 years (pretty standard).  Over the next 10 years while Joe is paying back his degree the prime lending rate goes up and down a little bit depending on the overall economy and many variables beyond his control.  Over that period of time the average prime interest rate is 5%.  This means that Joe paid about 7.5% interest on his loans as he paid them back.  So what is the overall amount of money that Joe ended up paying to his provincial government is $38,459.  Since the amount he originally owed was $27,000, that means he paid $11,459 in interest payments for the ability to borrow that money.  After ten years of making his monthly payments of $320.41, Joe is free and clear.

Scenario B: Joe’s cousin, Jane Diploma has a similar story to Joe, but she went to school in a province that did not charge a prime interest rate.  She also owed $27,000 at graduation and paid it off over 10 years (during which the prime lending rate average 5%) as well.  Paying off that money at 5% vs 7.5% means that after 10 years of making monthly payments of $286.38, Jane would have paid back $34,365.23, which means she paid $7,365.23 in interest over those 10 years.  That’s $4,094 or so less than Joe paid, so that’s how much the difference the change in interest rates made!

Scenario C: Just for kicks, Jane looks at how much money she would save in the long-term if she decided to make the same monthly payments that Joe had to, but at still kept her lower interest rate.  The first thing Jane noticed is that she would only have to make about 104 monthly payments as opposed to 120.  The total interest she would end up paying was $6.326.53, which is about $1,000 less than if she went with her original plan.  As far as Joe is concerned, let’s just say when he sees that number he wants to cry as thinks about how many trips to Cancun that could have been.

Keep It Simple Stupid

Now you should know I took some liberties with the way I presented these scenarios.  First off, I didn’t factor in that student loan interest is tax deductible.  This means that the overall difference between the three scenarios wouldn’t be quite as large due to tax savings.  I also didn’t factor in the effects of inflation over those 10 years which would have made the debt seem slightly smaller as time went on.  Finally, the way I calculated interest using an “average interest rate” doesn’t really work in terms of finding an exact number (because that fluctuating interest rate would have different effects depending where it was at what point in the loan payment process), but the principle stays the same and is accurately represented – that is that the interest rate on your student loan makes a big difference to your overall bottom line as the years pass.

These numbers tell us that there are more than one way to try and help the student cause as far as lobbying government is concerned.  Lowering tuition isn’t the only way to save us money.  We should be active in asking the federal government to match some of the provinces’ commitment to young people and drop its student loan lending rates from prime plus 2.5% (sometimes referred to as 250 basis points).  Since the federal governments picks up 60% of the student loan tab in most places in Canada, I don’t understand why this isn’t a bigger deal.  I also have to give kudos to the Manitoba government (who I’m not regularly a supporter of) for showing a genuine commitment to students.  In addition to this shiny new interest rate, the province will also pay you 10% of your total tuition back every year for six years if you stay and work in the province after graduating.  That’s a pretty good deal from where I’m sitting.  I think getting similar policies enacted across Canada would be a great goal for students, but unfortunately it will require us to do more than just post a “like or comment” poll on Facebook, and instead actually get out and vote once in  a while!