Variable vs Fixed Interest Rates Explained
Would you like a variable or fixed interest rate student loan?This question usually comes towards the end of the application process. Most likely you have already been approved for a loan and are about to electronically sign the documents. But hold on! Which option is actually best for you! Before jumping in to the agreement take a deep breath and figure out exactly what the different options mean in terms of total loan cost.
If you're not a finance major the financial jargon can be tough to comprehend. What is a variable interest rate student loan? How is the variable interest rate calculated? How will the variable rate change? What is a fixed rate student loan? How come the rates are so different.
Tons of great questions. Lets first look at the variable rate option.
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.
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 will 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% interest rate for 20 years you will effectively pay 7% in interest every year for 20 years. The 7% 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.
Fixed interest rate loans are generally more expensive in terms of interest for the student up front. 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.
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.