If you are a follower of the financial aid and student loan industry, you will have seen that there has been recent turmoil regarding how federal student loans are distributed and increased downward pressure on interest rates. In addition, a planned interest rate reduction for federally subsidized Stafford loans goes into effect in July 2010, from 5.6% to 4.5%. In July 2011, there will be another rate cut planned to 3.4%.

Thanks to the Student Aid and Fiscal Responsibility Act (SAFRA) passed in March, private banks will no longer be able to originate federal student loans for students attending schools affiliated with the Federal Family Educational Loan (FFEL) Program. The effect of this new bill is that starting in July, banks participating in FFEL will lose a substantial revenue stream and will start looking elsewhere to recover lost revenue. Due in part to these changes, banks are lowering their interest rates and fees to attract borrowers who might not normally be as willing to apply for a credit-based loan. You may be wondering, “What does that mean to me?” Two main things:

1. Lower interest rates = less money paid over the life of the loan
2. Historically low index rate = ability to pay more over the life of the loan

Sounds counter-intuitive, right? Let’s analyze the terms and discover the hidden meanings.

Interest rate: the percentage of a sum of money that is charged for its use; this number is usually derived from a variable index rate plus a “margin”.

For example, if you loaned me $100 for a year at 5% interest, when I pay you back… the total will be $105. That $5 is what you charge me for borrowing the money.

Index: A statistical indicator that measures changes in the economy in general or in particular areas. For student loans, the federal funds rate and the London Interbank Offered Rate (LIBOR*) are typically the most commonly used indices (The Free Online Financial Dictionary).

*For more information on LIBOR and the federal funds rate, they are published daily in the Wall Street Journal and available online at a wide variety of financial websites.

These indices change over time based on the performance of the economy. If the economy is great, they tend to be higher; if you’re doing poorly, or in our case, recovering from a severe global recession, they tend to be lower. These changes are all methods of financial controls to help expand or slow down the economy. If you don’t have a background in economics, the important thing to remember is that the Federal Reserve does not want our economy to grow or shrink too fast; Steady, gradual growth is always preferred to rapid growth because it is less financially risky and easier to forecast. Now that you know what these terms mean, I invite you to think about how a historically low index rate might affect your student loan. To get a firm understanding, there are a few key points to keep in mind:

1. All private student loans have variable interest rates (meaning they change); rates are generally reset every 3-6 months
2. Low index rates = economy in recession or an economy poised for high growth
3. Interest rates are based, at least partially, on index rates

When you connect the dots, you see that there is a distinct possibility that as the economy improves, so will the indices. The result? His variable the interest rate will rise along with the index and it will cost more money in the long run. Sounds a bit negative, right? Not necessarily. Because of these historically low index rates, you can actually get a private student loan (assuming you have good or excellent credit, or a creditworthy co-signer) at lower interest rates than a federal PLUS loan for parents. The game here is really finding a loan that has the best of all worlds. In this case, you want to find one that has a low “margin” number. You know when you see a loan offer and it says something like LIBOR + 3% or Prime + 2.5%? That “+X%” is a margin.

So your goal, the daring loan seeker, is to find a private loan that has a low margin and a low to medium index rate. The more stable the index, the more stable your interest rate will be. Keep in mind that you are not required to accept the first loan offer you receive and you have a 30-day window to apply for loans without receiving a credit penalty. As a responsible borrower, you are encouraged to shop around for loans and find a product that matches both your needs and financial capacity.