Variable vs. Fixed Interest Rates on Student Loans: Which Should You Choose?
Understanding the different types of student loan interest rates is key when deciding which kind of loan to take. This article will help you understand the differences.
Shopping around for a private student loan is about more than just choosing a lender. You also need to decide between the different loan options offered - a decision that can affect your repayment experience significantly.
One of the most important choices is between a fixed and variable-rate loan. We'll explain the difference below, and help you decide which option is right for you.
What is a Variable-Rate Loan?
A loan with a variable interest rate means that the interest rate will fluctuate throughout the loan’s term, depending on market conditions. If overall interest rates rise, then the rate on the loan will also rise. If interest rates drop, then the rate on the loan will drop as well.
Most lenders base interest rates on the London Interbank Offered Rate (LIBOR), a global interest rate that most global banks and lenders use. The interest rate on a variable-rate loan is often the LIBOR rate plus a certain amount.
Before you apply for a variable-rate loan, the lender will show a range of initial interest rates. The bottom end of this range will reflect the lowest possible interest rate, while the top end will show the highest possible interest rate. Remember, this is just the starting interest rate.
Lenders can change the rate on a variable-rate loan at any time, and the exact details will depend on each company’s internal policies. For example, both ELFI and Discover examine their rates once every three months, while Earnest changes their rates every month.
The starting interest rate on a variable-rate loan is often lower than the rate for a fixed-rate loan. That’s why borrowers who choose a variable-rate loan can save money on total interest by making extra payments.
How to Estimate Your Variable-Rate Payment
Even though it's impossible to predict the future, borrowers interested in a variable-rate loan can estimate how much their payments will change. Juno offers a variable-rate calculator where you can input the loan amount, APR and term. Then, you can choose a variable assumption: market projection, a +1 standard deviation and a +2 standard deviation.
The higher the standard deviation, the more interest rates will increase and result in higher monthly payments.
For example, let’s say you’re considering a $60,000 loan to pay for graduate school. If you choose a 10-year term with a 2% starting APR and variable-rate loan, your monthly payment will vary from $601 to $639. With a 2+ standard deviation, the payment can fluctuate between $697 and $1,016 a month.
Interest rates are at near-historic lows right now, which means rates are only likely to increase in the future. Before signing up for a variable-rate loan, understand what your monthly payment could be. Run a budget projection to verify that you can afford the highest possible payment. If you can’t, consider getting a fixed-rate loan instead.
If you plan on making major life changes soon, like having a child or starting a business, run the math and see if you can still afford the maximum possible loan payment.
Lenders usually have a cap on their interest rates, sometimes as high as 25%. The cap is the maximum interest rate the lender is allowed to charge.
What is a Fixed-Rate Loan?
A fixed-rate loan will have an interest rate that stays the same for the entire life of the loan. Payments will also stay the same. If you sign up for a fixed-rate loan with a $400 monthly payment, it will stay at $400 until you pay the balance off or refinance the loan.
Borrowers who like consistency may prefer a fixed-rate loan over a variable-rate loan, even if it means paying a higher interest rate at first.
Refinancing is Always an Option
Whether you have a fixed or variable-rate loan, you can refinance at any point to take advantage of lower interest rates or more manageable monthly payments. For example, if payments on your variable-rate loan increase, you can refinance to a fixed-rate loan with a lower rate, lower monthly payment or possibly even both.
If you have a fixed-rate loan and interest rates drop, you can refinance to a variable-rate loan to take advantage of the interest savings. You can also refinance one variable-rate loan to another variable-rate loan if you find a better offer from another lender.
Juno can help you to find a student loan or refinance a loan at the most competitive possible rate. We get groups of buyers together and negotiate on their behalf with lenders to save them money on private student loans and private student loan refinance loans.
Zina Kumok is a freelance writer specializing in personal finance. A former reporter, she has covered murder trials, the Final Four and everything in between. She has been featured in Lifehacker, DailyWorth and Time. Read about how she paid off $28,000 worth of student loans in three years at Conscious Coins.