As is the case with many financial decisions, you should consider your personal risk tolerance and time horizon before making the decision.
Fixed Interest Rate Student Loans
With a fixed rate loan, the interest rate will never change. As a result, your total monthly payment will never change and any future interest rate changes will not impact your monthly payment.
Fixed rate loans typically have a higher initial interest rate than variable rate loans, but the rate never changes over the life of the loan. You are paying a higher initial interest rate to eliminate any risk of future interest rate increases.
When interest rates are low by historical standards (as they have been since 2009), fixed rate loans are more attractive than variable rate loans because interest rates are likely to rise in the future. When interest rates are higher than average, the opposite is true.
Variable Interest Rate Student Loans
Variable interest rate loans typically offer a lower initial rate than fixed rate loans, but the rate will fluctuate over time.
Most variable rate loans are tied to an underlying interest rate benchmark, such as the Prime Rate or the London Interbank Offered Rate (LIBOR). These benchmarks are set by central banks, such as the Federal Reserve. When the economy does poorly, the Federal Reserve and other central banks reduce short-term interest rates to encourage borrowing. When the economy heats up, the Fed often increases interest rates to slow economic growth and combat rising inflation.
When you apply for a variable interest rate loan, lenders use one of these benchmarks as the baseline rate. The lender then adds a fixed profit margin to the baseline rate to achieve a profit. Usually, the fixed margin is dependent on your credit profile. Excellent credit will reduce the fixed margin while poor credit will increase the margin.
The interest rate on a variable loan may adjust monthly, quarterly, or annually, depending on the underlying benchmark. The fixed profit margin (based on your credit) never changes. Some lenders limit how much your interest rate can increase during each adjustment period, and most limit the maximum interest rate change over the life of the loan.
For example, I previously obtained a private student loan through Discover Bank. The variable interest rate was tied to the 3-month LIBOR rate, which meant that it was adjusted four times each year (once per quarter). The fixed profit margin never changed. When the 3-month LIBOR rate increased slightly, so did my monthly payment.
Other Important Considerations
There are a few key considerations that apply to both fixed and variable rate loans.
The Loan Term – Most companies offer a variety of loan terms that you can choose from when obtaining a loan (such as 5, 10, 15, or 20 years). Shorter length loans will offer a lower interest rate than longer loans, all else equal. If you can afford the higher monthly payments, you can obtain a lower rate by choosing a shorter length loan.
Your Credit – Federal student loans offer a fixed interest rate that does not depend on your credit. Private student loan rates are largely determined by your creditworthiness as a borrower. If you have excellent credit, you will qualify for the lowest possible interest rate. If your credit needs work, you will need to obtain a co-signer with excellent credit, or you should expect to pay a higher interest rate.
Choosing Between Fixed and Variable Rate Loans
If I were choosing a new loan, here is how I would approach the decision.
Fixed Interest Rate Loans
If you’re uncomfortable with fluctuating monthly payments, then consider a fixed rate student loan. The interest rate and required monthly payment never change over the life of the loan.
In our current economy, locking in a fixed interest rate can be beneficial. Rates are expected to rise over the next couple of years, which will negatively impact variable rate loans. If you plan to pay off your student loan over a long period of time, choosing a fixed interest rate will guarantee your monthly payment, regardless of any future interest rate changes.
Student loans originated by the government always carry a fixed interest rate, but it’s often higher than the best rates offered by private lenders. If you have an outstanding federal loan, you might be able to obtain a lower fixed interest rate by refinancing.
Also, keep in mind, you can refinance multiple times if interest rates take an unexpected turn. For example, if you obtain a fixed-rate loan and interest rates fall, it’s possible to refinance into a variable-rate loan at the lower rate.
Variable Interest Rate Loans
If you plan to pay off your loan relatively quickly, or if you expect interest rates to remain stable or decrease, a variable rate student loan can save you money because the initial interest rate will be lower than a comparable fixed rate loan.
Because interest rates have been historically low since the 2009 financial crisis, it is reasonable to expect rates to rise in the future. However, history has shown that it’s nearly impossible to predict how quickly interest rates will rise or fall.
If interest rates increase, you should be prepared to make higher monthly loan payments. The longer it takes you to pay off the loan, the higher your probability of experiencing an interest rate increase. Although you can mitigate some of this risk by choosing a lender that caps its variable rates.
Have you decided between a fixed and variable interest rate student loan? Share with a comment below.