Student loans are often necessary to pay for college or graduate school. However, choosing a variable or fixed interest rate for your student loan can be confusing.
It is not usually black and white to know which of these interest rates is a good deal. Hence, you will need careful consideration and research.
This comprehensive guide examines the key differences, pros and cons, and provides tips on deciding which option may be better for your situation.
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Variable vs. Fixed Interest Rates – The Key Differences
Student loans generally offer the choice between a variable or fixed interest rate when first taking out the loan.
- Variable interest rates fluctuate over time based on market conditions. The rate is tied to an index, such as the LIBOR or Prime Rate, and adjusts periodically (often annually) as the index changes.
- Fixed interest rates remain the same over the entire term of the loan. The rate is set when you first take out the loan and does not change.
Rates for fixed and variable loans are typically set based on current market rates at origination.
However, their differences lie in how they change over the life of the loan:
- Variable rates can increase or decrease over time, while fixed rates remain static.
- Variable-rate loans carry more interest rate risk, while fixed-rate loans provide certainty.
- If interest rates decrease, variable-rate loans can become cheaper than fixed. But if rates increase, fixed-rate loans would provide a better rate.
The Pros and Cons of Variable Interest Rates
Let’s consider the ups and downsides of variable interest rates:
Pros
- Potential for lower long-term costs. If interest rates go down, your monthly payment amounts will decrease. This flexibility can save you money over the life of the loan.
- It’s a good option when rates are low. If rates are low when you first take out the loan, there’s a good chance they will increase. Variable rates allow you to take advantage of lower short-term rates.
- Interest savings can be applied to the principal. If rates decrease, you can apply the monthly savings toward paying down your principal balance faster.
Cons
- Unpredictable payments. Your monthly payments will vary based on interest rate changes, making it harder to budget.
- Risk of payment spikes. If rates increase significantly, your monthly payment amounts could go up drastically. This could not be easy to handle financially.
- Potential for higher long-term costs. There’s no cap on how high variable interest rates can go. You may pay more total interest costs if rates trend upward over time.
- Difficult to compare origination rates. It’s hard to compare initial variable rates to fixed rates due to their inherent differences.
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The Pros and Cons of Fixed Interest Rates
Here are the benefits and drawbacks of choosing fixed interest rates:
Pros
- Predictable payments. Your monthly payments remain constant over the entire repayment term, making budgeting easier.
- Hedges against rate increases. Fixing your rate locks it in place regardless of future rate hikes, protecting you from spikes.
- It may be lower than variable rates initially. Fixed rates are sometimes lower than variable rates when first taking out the loan.
Cons
- Ineligible for rate decreases. You lose out on taking advantage of rate decreases that could lower your long-term costs.
- May pay higher long-term costs. If interest rates decrease, you’ll be stuck paying a higher fixed rate instead of benefiting from a lower variable rate.
- Lacks flexibility. You cannot adjust your payment amounts or apply interest savings toward the principal like you can with a variable loan.
Tips on Deciding Between Variable and Fixed Rates
So, how do you decide which option is right for your situation? Here are some tips:
- Consider your risk tolerance. Those more risk-averse may want the stability of a fixed rate. Variable rates are optimal only for those comfortable with rate fluctuations.
- Look at rate forecasts. Experts publish interest rate predictions you can evaluate to help inform your decision about potential rate movements.
- Understand the index. Research the index your variable rate will be based on to understand what drives changes.
- Think long-term. It’s impossible to know exactly how rates will change over the life of your loan. Focus on big-picture trends.
- Compare origination rates. Variable rates are generally lower at first but carry uncertainty. Run the numbers for both options.
- Evaluate your finances. Your ability to handle payment increases can help determine if variable rate risk is affordable.
- Consider refinancing. You may have opportunities to refinance if you select a fixed rate and rates decrease substantially.
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Final Thought
There’s no definitive right or wrong option when choosing between variable and fixed student loan interest rates. Each carries its own set of pros, cons, and risks.
Analyze both your finances and risk tolerance. For many, locking in fixed rates provides welcome payment certainty, even at the expense of potential long-term savings.
But for others, variable rates offer the chance to take advantage of lower rates over time. Carefully weigh both options before making your decision.
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