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When you apply for a private student loan or refinance your student loan, you often have a choice between variable and fixed interest rates. Variable rate loans can be tempting as the advertised rates are low. But what’s the catch?
In this breakdown of variable rate vs fixed rate loans, find out the differences and benefits of each type of interest rate.
How Variable Rate Loans Work
Variable interest rates are only available on private student loans and refinance loans.
With variable rate loans, the interest rate on your loan can change, possibly monthly. They often start with lower interest rates than fixed rate loans, but the interest rate may increase depending on the index used by the lender.
Most private student loan companies use the London Interbank Offered Rate (LIBOR) as an index, although who should change. LIBOR is designed to be used by banks and financial institutions when lending to each other, but consumers should be aware of LIBOR as it can affect the interest rates you get on student loans, mortgages and even commercial loans.
To calculate your interest rate, private student loan lenders will charge you the LIBOR rate plus their margin. For example, the three-month LIBOR rate on January 13, 2021 was 0.24%. If a lender had a 3% margin, your interest rate would be 3.24% (0.24% LIBOR + 3% margin = 3.24%).
Keep in mind that the LIBOR rate is currently at an all time high. In contrast, the three-month LIBOR in December 2018 was 2.81%. With this LIBOR rate, your interest rate would be 5.81% (2.81% LIBOR + 3% margin = 5.81%), a significant difference.
With variable rate student loans, lenders have a cap on the interest rate that can reach. For example, Discover has an 18% cap on variable rate loans, which means your interest rate will never exceed that number, even if LIBOR skyrockets. The lender’s limit will be stated on the loan application and the loan disclosure agreement.
Benefits of variable rate loans
- You can get a lower interest rate. Variable rates are generally lower than fixed rate loans, especially at the start of your repayment term. As of January 2021, some lenders have been offering variable rate loans with rates as low as 1.24%.
- You could save more money. As you can get a lower rate with adjustable rate loans, you can save more money over the life of your repayment. With a lower rate, less interest is accrued on your loan.
- The additional payments will reduce the principal. If you pay more than the minimum required payment, more of your payments will go to principal rather than interest charges since you have a lower initial rate, which will help you pay off the loan faster.
Disadvantages of variable rate loans
- Your interest rate may go up. Although variable rate loans usually start with low rates, there is no guarantee that the rates will stay low. If the market changes, you may see your rate increase to the lender’s cap.
- Your monthly payment may increase. As the interest rate on your loan fluctuates, your monthly payments can also change. If the interest rate goes up, your monthly payment can grow significantly more, making it difficult to plan or budget, and it can be more than you can afford.
- The total cost of reimbursement is unknown. Because your rate is not locked in and may change, it is impossible to know your total cost of repayment. If the rate increases dramatically, you could end up paying thousands more in interest charges.
How Fixed Rate Loans Work
With a fixed rate loan, you will have the same interest rate for the life of your loan. Instead of using an index like LIBOR to determine your rate, lenders decide your interest rate based on your credit score, income, and income. co-signer of the loan.
Federal student loans only charged fixed interest rates, and borrowers all get the same rate regardless of their creditworthiness. Private student loan lenders and refinance lenders typically offer fixed and variable rate loans.
Benefits of fixed rate loans
- You have a predictable monthly payment. With a fixed rate loan, your monthly payment will never change, so you can create a consistent budget.
- You know exactly how much you will pay back on your loan. Since interest rates and payments don’t fluctuate, you can tell how much you’ll pay back by simply calculating the sum of the number of payments you need to make.
- Your interest rate never changes. Fixed rate loan rates stay the same for the life of your loan, so you don’t have to pay attention to clues or market movements.
Disadvantages of Fixed Rate Loans
- Your loan may have a higher interest rate than some variable rate loans. Lenders generally charge higher interest rates on fixed rate loans than the initial rate offered on variable rate loans.
- You cannot profit from changes in the market. Since fixed rates never change, you cannot take advantage of lower rates, which means lower monthly payments, if LIBOR goes down. The only way to get a new rate is to refinance your student loans.
- You can pay more over time. Since fixed rate loans can have higher rates, you could pay more interest charges over the life of your loan.
Variable or fixed rate student loan: which one to choose?
When choosing between fixed or variable rate loans, use the following tips to help you choose the one that’s right for you.
When a fixed rate loan is best
- You need more time. If you think you need more time to repay your loan (10 years or more), opting for a fixed rate loan is better than a variable rate loan. With a longer loan term, interest rates are more likely to rise, so choosing a fixed rate loan is the safest choice.
- You want stable payments. If you are worried about your monthly payments going up and you want more stability, a fixed rate loan is a better choice.
- You worry about interest rate changes. If you think interest rates are going to fluctuate in the near future, choosing a fixed rate loan can give you more peace of mind.
When a variable rate loan is best
- You think interest rates will stay stable. If you think market trends indicate that interest rates will remain stable over the life of your loan, an adjustable rate loan may be a smart bet.
- You choose a short term loan. With a short term loan, like five years, large market fluctuations are less likely, so an adjustable rate loan can help save you money.
- You want to aggressively pay off your debt. If you want to pay off your student loans as quickly as possible and plan to make additional payments, taking advantage of the lower initial rate will help you get rid of your debt faster.
Fixed or variable student loan rate: student loan refinancing
Like other private student loan lenders, student loan refinance lenders generally offer fixed and variable rate loans. You can refinance private and federal student loans to potentially lower your interest rate, lower your monthly payment, and save money over time.
When refinancing your debt, an adjustable rate loan can make sense when you want to pay off your loans sooner than expected. However, if you have significant debt and it will take you several years to pay it off, a fixed rate loan might be a better option for you.
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