Student Loan Interest Rate Is Set to Double: How You Can Prepare

Drowning in debt

After having dealt with at least one big part of the so-called "fiscal cliff" -- the broad tax increases that would have taken effect this year -- and having failed to stop another -- the sequester -- the government now faces yet another economic cliff event, this time affecting student-loan borrowers.

Without government action, rates on subsidized student loans will double as of July 1, putting further pressure on students who already face the uncertain prospects of whether they'll be able to get jobs to pay off their loans after they graduate.

Why Student-Loan Debt Is a Big Problem

Student-loan debt has become an increasingly troublesome financial burden not just on recent graduates but on the entire U.S. economy.

Student-loan balances outstanding passed up other popular types of debt such as auto loans and credit-card debt back in 2010, with the Federal Reserve Bank of New York reporting that total student loan debt was just shy of the $1 trillion mark as of the first quarter of 2013.

Even worse, while overall indebtedness in most areas, including home mortgages, has declined in the years since the financial crisis, student-loan debt has steadily risen, now standing 50 percent above its levels from just four years ago, according to the New York Fed.

Before you panic about your existing loan balances, though, it's important to understand that the debate over the future of student-loan interest rates doesn't affect loans made before the July 1 deadline. For those loans, whatever interest rates were in place when you got your loan -- such as the 3.4 percent rate that applied to loans for the 2012-2013 school year -- won't change.

Déjà Vu All Over Again

If this debate sounds familiar, it's because students went through the same crisis last year. In the end, the government simply agreed to extend the 3.4 percent rate for a year and put off making a bigger policy decision until now.

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Various lawmakers and President Obama have come up with a wide range of competing proposals.
The president's proposal would reduce rates on both subsidized and unsubsidized loans, with roughly 3 percent rates for subsidized and 5 percent for unsubsidized loans being linked in future years to the yield on 10-year Treasuries, with a markup of 0.93 percentage points for subsidized and 2.93 percentage points for unsubsidized loans. The link to Treasuries means that rates could rise for students taking future loans, although each loan would be locked in with rates as of the year it was taken.

A competing GOP proposal from the House of Representatives would also base rates on Treasuries, with a 2.5-percentage-point markup on Treasury yields equating to a rate of roughly 4.5 percent based on current yields. Moreover, under the House's plan, the interest rate on student's loans wouldn't be set until after they graduate, introducing new uncertainty to the borrowing process.

Competing Senate plans take similar tacks but have different effects. Senate Republicans would use a 3-percentage-point markup versus Treasuries, while Senate Democrats would like to tie loan rates to the lower 3-month Treasury rate. In addition, various individual lawmakers have proposed temporary fixes, including Sen. Elizabeth Warren's (D-Mass.) proposal to set the 2013-2014 rate at 0.75 percent.

Planning for the Future

At this point, students have limited options to try to protect themselves against a potential rate hike.

Unlike homeowners, who have rushed to refinance their mortgages in recent years to take advantage of low rates, there's no viable way to accelerate borrowing on student loans without resorting to private loans, which already carry much higher interest rates than even the most draconian of the Washington proposals covering federal student loans.

The better solution is to focus on what you can control -- because while interest rates are out of your hands, there are a host of things you can do to reduce the cost of college.

Taking steps to reduce expenses beyond required tuition and fees can go a long way toward cutting your eventual financial-aid bill. By acting now to explore alternatives like cheaper room-and-board or other housing options, you might be better able to make ends meet. And

The most important lesson that the current controversy underscores is the need for parents to do everything they can to avoid having to rely on government loans in the first place. Boosting your own college savings -- whether through a 529 plan or one of the alternatives -- will leave you less dependent on the ever-changing political landscape in Washington, as well as leaving your children far better prepared to enter adulthood on a sound financial footing after they graduate.

To learn more about federal student loans, visit the U.S. Department of Education's Federal Student Aid Office here.