Variable vs. Fixed Rate Student Loans
Understanding interest rates is important because your rate determines how much you’ll pay on credit cards and other loan products, including student loans. Variable interest rates can increase or decrease over time, while fixed rates stay the same over the life of the loan.
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Student loans are one of the ways to help students achieve their dreams of obtaining their degree. When taking out student loan debt, it is vital to be fully informed about all of the conditions and terms that may apply — including the interest rate.
The interest rate on a loan represents the amount of money you pay back to the lender in addition to the amount you originally borrowed, otherwise known as the principal. Loan rates vary greatly from lender to lender as well as by loan type.
There are two types of interest rates: fixed and variable. Both types of interest rates highly impact your overall cost of borrowing and monthly payment amounts, and each come with their own advantages and downsides.
On this page:
- How Do Student Loan Interest Rates Work?
- Fixed Rate vs. Variable Rate Student Loans
- Fixed or Variable Student Loan: Which is Best for You?
How Do Student Loan Interest Rates Work?
The interest rates that banks, lenders, and other financial institutions charge and pay on deposits is one of the main areas of competition between financial institutions.
If you have excellent credit, you’re likely to get a lower interest rate when you borrow money than someone with a spotty credit history. This is because the bank believes people with good credit are more likely to stick to their repayment plan. If you’re someone a bank or lender considers to be risky, you’re going to pay higher rates in most cases.
Three main factors are considered when determining interest rates on both private and federal student loans. First, there is the Federal Reserve, which sets federal funds rates that affect variable interest rates. There is also a consideration for U.S. Treasury notes and bonds, which primarily affects fixed interest rates. Depending on how banks or lenders are performing at any time, they might change their rates based on their assessment of the interest rate environment.
The term “prime rate” is important to understand when considering the differences between variable and fixed interest rates. The prime rate is what banks will charge the most creditworthy borrowers. It’s usually above the Fed’s rate but below the average variable interest rate. If you don’t have an excellent credit score, you’ll likely be charged more than the prime rate — in some cases, significantly more.
>> Read More: See Current Student Loan Interest Rates
Federal Student Loans
Interest rates on federal student loans are standardized, so everyone who is eligible for federal student loans pays the same interest rate regardless of credit score. Further, rates are fixed for the life of the loan.
Interest rates are set by federal law and can vary based on the time of disbursement. For example, the interest rate on Direct Subsidized Loans first disbursed between July 1, 2014, and June 30, 2015, was 4.66%, whereas the rate on new student loans for the 2018-2019 school year is 5.05%.
Private Student Loans
Private student loan interest rates are usually higher than federal loans. A 2017 LendEDU report found the average interest rate on private student loans was 7.99%, while the interest rates on federal student loans ranged from 4.45% to 7% at the time.
Fixed Rate vs. Variable Rate Student Loans
What Is a Variable Interest Rate?
Variable interest rates change based on an underlying interest rate index, which is something lenders and financial institutions use as a guide for determining their own rates. LIBOR, which stands for London Interbank Offered Rate, is one such benchmark that reflects the interest rate at which banks lend money to each another in the international market. Over time, the underlying interest rate index will move up and down with the economy.
The movement in interest rates within the index carries over to the student loan market. If the interest rate on the underlying index goes up, the variable interest rate the borrower pays will follow suit. If the interest rate on the underlying index goes down, the variable interest rate the borrower pays will similarly decrease.
For example, the rate you pay on a variable rate student loan may be the LIBOR rate plus 2%. So, if the LIBOR rate increases by 1%, the variable rate you pay will also increase by 1%.
What Are the Pros and Cons of a Variable Rate Student Loans?
The initial interest rate on variable rate loans can be lower than that on fixed-rate loans, but that doesn’t mean it’s always the better option.
Students who elect to borrow private loans with variable interest rates could benefit at the time of borrowing; however, although the initial rate is lower, there’s no way to predict when the rate on the underlying index will change.
When choosing between variable- and fixed-rate student loans, you should take into account the possibility of interest rate changes and the potential impact on your budget.
What Is a Fixed Interest Rate?
A fixed-rate student loan is one where you’ll pay the same amount in interest over time. If you get a loan with a 6% interest rate, you’ll always pay 6% until the loan is paid off.
The rate you pay is not tied to the economy or any underlying index rate. Unlike variable-rate loans, you have no exposure to changes in market interest rates, and you’re able to lock in your rate at the time of borrowing.
What Are the Pros and Cons of a Fixed Rate Student Loan?
Fixed-rate loans are generally more expensive over the long term because their rates are often higher than what you’d get with a variable rate loan, at least at the onset. This is the primary downside.
However, fixed-rate student loans mean you can predict your monthly payments with absolute certainty. The interest rate will be fixed for the entire life of the loan, and the only way this could change is if you decide to refinance with a private lender and take out a new loan. Private loan providers also offer fixed-rate loans, although they can be more challenging to obtain because of more stringent credit requirements.
One thing to note is that federal student loan interest rates change each year, so you may have a different rate than someone who took them out even just the year prior to you.
Fixed or Variable Student Loan: Which is Best for You?
To start, you should know that all of the best places for private student loans offer both variable and fixed rates to borrowers and will give you the option to choose which you want.
Although the right loan depends on your situation, many borrowers prefer fixed-rate loans. This allows you to plan ahead and always know what you’ll be paying. It can be tempting to go with a more competitive variable-rate loan, but it’s always possible the rate will go up and take your monthly payment amount with it.
Fixed-rate loans are an especially good option if you believe interest rates will rise in the future. Because student loan borrowers have different risk tolerances, it’s important to consider which is more important to you: predictability in the overall cost of borrowing and steady loan payments, or the potential for a lower payment with the lowest rate possible — at least in the beginning.
Author: Ashley Sutphin