Student Lenders' Fixed-Rate Offerings Bring Opportunity, Risk

College students may get a break this year with two new fixed-rate student-loan products on the market. Whether the companies offering these loans will see benefits, though, is no sure thing.

Last week, U.S. Bancorp's (USB) U.S. Bank announced a fixed-rate loan with annual percentage rates between 7.8% and 8.46%, while earlier this month, Wells Fargo & Co.'s (WFC) student-loan segment launched fixed-rate loans with APRs ranging from 7.29% to 12.77%. They expect the rates to appeal to families worried about interest rates rising down the line.

In that situation, fixed-rate products could be more attractive than their variable-rate counterparts, as variable rates are influenced by the Federal Reserve's prime rate or the London interbank offered rate. However, borrowing costs would rise for the companies as well, potentially causing a mismatch between increasing financing expenses--money going out--and a flat student-loan rate--money coming in.

With college costs soaring and federal aid on the chopping block in current budget talks, more families are turning to private loans to fill the funding gap. Student-loan companies are in a heated battle for the borrowers, trying to regain ground after originations declined during the recession. The situation is brightening: Origination volume at SLM Corp. (SLM), the market's largest lender, increased 12% in the latest quarter.

Fixed interest rates may well make sense for borrowers. Libor dropped by about 5.5 percentage points during the credit crisis, according to Mark Kantrowitz, publisher of financial aid website FinAid.org, "so it could just as easily rise by that amount or more during the economic recovery."

If there is such a jump in financing costs, lenders could compensate by raising rates on variable-rate student loans. That happened during the financial crisis, when the credit markets froze and companies had to pay high fees to borrow. Private-loan rates for new borrowers averaged about 10% during that time, according to Kantrowitz. He said that every 1 percentage point increase in interest rates raises a student's monthly payment by about 5% on a 10-year loan, or 9% on a 20-year loan.

SLM, commonly known as Sallie Mae, offers a variable-rate student loan at Libor plus 2 basis points to Libor plus 9.875 basis points, or an APR of 2.25% to 9.37% at current rates. Spokeswoman Patricia Christel said the company continues to "look at new ideas and products that can meet our customers' needs."

Referring to private student loans in general, Kantrowitz said, "I wouldn't be surprised if rates for current borrowers peak over 20% if interest rates begin rising." While Fed rates won't jump overnight, such a hike could ultimately make U.S. Bank's 7.99% rate look like a steal.

U.S. Bank declined to provide details on its financing strategy, but spokesman Tom Joyce said, "We will account for any new fixed-rate new student loan volume as we do for any and all fixed-rate assets at U.S. Bank." He said the company "closely monitor[s] the interest rate environment in terms of funding, and take[s] the steps necessary to maintain a low interest rate risk environment."

Wells Fargo, which also offers variable-rate products, declined to comment on its loan-financing strategy, citing the company's pre-earnings quiet period.

Beyond dealing with potential funding complications, the fixed-rate lenders also will have to overcome consumers' tendency toward financial nearsightedness. Sameer Gokhale, an analyst at Keefe Bruyette & Woods, expects any impact from the new offerings to be marginal for now because borrowers often don't grasp the long-term risks associated with variable rates. Many homeowners were caught off-guard when monthly payments on their adjustable-rate mortgages jumped in the middle of the last decade.

Still, Gokhale does expect other lenders to enter the fixed-rate fray, assuming they can minimize their own borrowing-cost fluctuations. "It seems like a very workable option," he said. "The question is just how much it costs them to hedge this kind of exposure."

-By Melissa Korn, Dow Jones Newswires; 212-416-2271; melissa.korn@dowjones.com

US Bancorp (NYSE:USB)
Historical Stock Chart
From Jun 2024 to Jul 2024