NEW YORK -- College students in the U.S. who take out federal loans are likely to see interest rates jump -- potentially by a percentage point or more -- in the coming academic year.
Last year, the government began to peg rates on most student loans to the Treasury 10-year note. Stafford loans, the most widely borrowed, carried an undergraduate rate of 3.86 percent for the 2013-2014 school year. In the past three months, the 10-year yield has traded 0.80 to 1 percentage point higher than a year ago, which means education borrowing costs may rise.
Interest rates for the school year beginning July 1 will be determined following the Treasury's 10-year note auction May 7. While interest rates are fixed for the life of an education loan, borrowers take out a separate loan for each school year. Federal loans make up most of the $1.2 trillion in outstanding education debt, which has become a drag on the economy in recent years as many borrowers struggle to repay.
"The interest rates that people are going to be paying on these student loans are going to go up, making the cost of college that much more burdensome," said David Ader, head of interest rate strategy at CRT Capital Group LLC. "As the years come on, they're more likely to come up than come down."
In the current year, graduate Stafford loans had a 5.41 percent interest rate, while PLUS loans for graduate students or for parents paying their undergraduate children's college costs were set at 6.41 percent.
The Congressional Budget Office projected rates for the 2014-2015 school year of 5.09 percent for undergraduate Stafford loans, 6.64 percent for graduate Staffords and 7.64 percent for PLUS loans, according to the Consumer Financial Protection Bureau.
Even with a probable increase, rates on most government loans will still be below the levels before Congress began tying them to the 10-year note. In the academic years starting in 2011 and 2012, the Stafford rate for undergraduate and graduate students regardless of their income levels was 6.8 percent while the rate on PLUS loans was 7.9 percent.
While rates are rising, federal loans still are a safer option than private loans, according to Pauline Abernathy, vice president of the Institute for College Access & Success, a nonprofit research and advocacy group in Oakland, Calif. Private loans often carry variable interest rates and don't have the same kinds of protections as government loans, such as income-based repayment.
Here's how Congress set the rates last year: It uses as a base the yield on the Treasury 10-year note auctioned prior to June 1 of each year. That rate was set at 1.81 percent in May 2013. For undergraduate Stafford loans, it added 2.05 percentage points; for graduate Staffords, it added 3.6 percentage points; and for PLUS loans, it added 4.6 percentage points.
Treasury "rates were distorted" last year, said Michael Pond, head of global inflation-market strategy for Barclays Plc. The U.S. Federal Reserve bought "an unusually large amount of 10-year notes last year," which drove the yield down, he said.
The Fed purchased $540 billion of Treasury securities and $480 billion of mortgage bonds last year at a combined pace of $85 billion per month to help keep borrowing costs low and stimulate the economy.
When Congress changed how it sets student loan rates, it also agreed to cap them, at 8.25 percent for undergraduate Stafford loans, 9.5 percent for graduate Stafford loans and 10.5 percent for PLUS loans.
Students who didn't benefit from the new rate-setting method were those from low-income families who qualified for subsidized Stafford loans. They went to a 3.86 percent rate in 2013-2014 from 3.4 percent in the previous two years.