Variable vs Fixed Interest Rates Explained
Financial assistance is a saving grace for many people who otherwise could not afford the cost of college tuition. Student loans are one of the ways that help make higher education more affordable and provide means for students to achieve their dreams of obtaining their degree. As you take out your student loans, it is vital to be fully informed about all of the conditions and terms that may apply. One of the most important things to take into consideration as you browse various loan options is the interest rate.
The interest rate on a loan is the amount of extra money you will have to pay back to the lender outside of the amount you originally borrowed. The interest is comparative to a reward for the loan provider as they have done you a favor by providing you money. These rates vary greatly from loan provider to loan provider, and even from loan type to type. There are many factors that affect interest rates and loans have different characteristics. Two types of loans are those with fixed interest rates or variable interest rates.
What is a Variable Interest Rate Student Loan?
In short, variable interest rate loans have interest rates that change with some underlying interest rate index. An underlying interest rate index is a benchmark of sorts. To keep it simple, it is a big important rate that all the banks watch to price their own rates. Over time the underlying interest rate index will move up and down with the economy. The variable interest rate you pay will be a derivative of the benchmark rate. In short, a variable rate changes over the life of the loan with the market. As of 2017, about 94% of new private education loans are originated with variable interest rates.
The movement in interest rates within the index will directly carry over to the student loan market. If the interest rate on the underlying index goes up, the interest rate that the borrower will pay will also move up. If the interest rate on the underlying index goes down, the interest rate that the borrower will pay will also move down. For example, the benchmark rate may be the London Interbank Offered Rate (LIBOR). The rate you pay on your student loan may be the LIBOR rate plus 2%. So if the LIBOR rate increases by 1%, the rate you pay will also increase by 1%.
Students that elect to borrow with a variable interest rate could benefit from a lower interest rate at the time of borrowing. The interest rate is lower because there is less risk to the bank. If interest rates move higher, the bank could move the interest rate higher too to avoid losing out. When choosing between variable and fixed rate student loans the borrower should take into account the possibility of interest rate changes.
What is a Fixed Interest Rate Student Loan?
A fixed interest rate student loan is pretty straightforward. Over the course of the loan you will pay the same interest rate to the bank. If you are offered a 7 percent interest rate for 20 years you will effectively pay 7 percent in interest every year for 20 years. The 7 percent you pay is not tied to the economy or any underlying interest rate index. Unlike variable rate loans, you have no exposure to changes in interest rates in the market.
Fixed interest rate loans are generally more expensive because their rates are often higher than variable rate loans. This is the case because the bank is taking on additional risk in issuing the loan. The bank needs the extra wiggle room in the rate to protect themselves from rising interest rates. So why would I choose a fixed interest rate over a variable one? Well as the borrower you are now able to predict with absolute certainty the exact cost of your loan.
Fixed interest rate student loans are a good option to consider if you believe that interest rates will rise in the future. Federal student loans have fixed interest rates. The interest rate of your federal loan will be fixed for the entire life of the loan, and the only way this could ever change is if you decide to refinance with a private lender. One thing to note about the interest rates of federal loans is that the initial rate changes each year so you may have a different rate than someone who took them out even just the year prior to you. Private loan providers also offer fixed-rate loans, which can be more challenging to obtain.
So now that we understand the basics of variable and fixed interest rates, we can now look at the best options. Every student is in a different financial situation. Every student has a different tolerance for risk. If you are on the fence and are unable to decide between a variable and fixed rate, why not mix and match. For example, say you will need two loans for the next two years. You can diversify by taking one variable rate, and one fixed rate loan. We mix and match everything else, why not our student loan interest rates. If interest rates stay stable, variable interest rate student loans are your best best. If interest rates become volatile, you are going to wish you took a fixed rate student loan.