fixed rate variable rate student loan consolidation

Should I Consolidate with a Fixed or Variable Rate Loan?

Michael Lux Blog, Consolidation, Student Loans 0 Comments

If you are consolidating your student loans with a private lender, one of the most important decisions you will make is the fixed-rate vs. variable-rate decision.  On the surface, there isn’t much to consider.  Pick a fixed-rate and your interest rate never changes over the life of the loan.  Pick a variable-rate, and your interest could go much higher over time.  One is a bit riskier, but has a reward; while the other is more of a safe bet.

If you are smart, the analysis does not stop there.  Before making the decision, there are many factors that are not nearly as obvious that need to be considered.

Variable-Rate Ceiling

If you read the fine print, most loans will have a ceiling for the variable-rate option.  If they don’t, consider it a red flag.  Knowing the ceiling of the variable rate loan is extremely helpful, because it gives you the worst case scenario.  Nobody wants to pay the maximum rate, but because the possibility exists, you need to know this detail.

Interest Calculations

Interest rates are normally tied to an index.  As the index goes up, your interest rate goes up.  Some of the more common index are the LIBOR rates and treasury bond rates.  A variable-rate loan interest starts with the index rate and then typically adds an additional amount of interest.  For example, your student loan could be set at the One Month LIBOR plus 1.7%.  That means as the LIBOR goes up, your interest rate goes up.

Once you know the index that your rate is tied to, and the number that is added to your index rate, you can look at historic values to get an idea of how fast your interest rates can change and where they might be headed.  Right now we are in a market of near historic low rates.  While it is technically possibly for a variable-rate loan to go lower, it is highly unlikely and really can’t go much lower than what it already is.

Your Comfort Level

Once you have a better idea of how the variable-rate interest is calculated, you can think about those range of numbers as it pertains to your budget.  If a short-term variable-rate loan has low interest because you will be paying it off in as little as five years, it could be very tempting.  However, if this variable-rate loan has payment that is at the maximum you can comfortably afford, you may want to look in another direction.  If you still have room in the budget for higher payments, or if you plan on paying more to knock out the loan as soon as possible, the appeal for the ultra-low variable-rate loans grows.

How Long Will You Take?

Perhaps the biggest question you need to ask yourself when choosing a repayment plan is how long am I going to take.  You want to look at this from several different perspectives.  Run the numbers once if you are optimistic about future income and ability to pay.  Next try to do a realistic assessment of what you think is most likely.  Finally, do a more conservative analysis of your ability to pay.

Once you have a pretty good idea of the length of time you will have this loan, you can make a very informed decision about the interest rate type that works best for you.  If odds are very good that you will be paying it off in 3-5 years, the reduced rate of variable interest seems like a good option.  If you might still be paying off the debt in 15-20 years, locking in a fixed interest rate during a period of historic low interest rates is probably the way to go.  If you fall in the middle, the many factors previously discussed all come into play.

A Trick to Finding a Good Deal

If you are thinking about consolidating your loans on the private market, you should be applying to a number of different companies.  Presently, there are five companies that offer interest rates below 2%.  With a huge list of student loan consolidation options, shopping around could save you a fortune.

You can use your research from shopping around to evaluate the fixed-rate vs. variable-rate decision.  If all the lenders seem to be offering you 3% variable and 5.5% fixed, but one lender offers 3% variable and 4.5% fixed, it would indicate that the 4.5% fixed might be a really good deal.

Bottom Line

Lenders offer you these two options because they would be happy to lend you the money under either method.  That means that there usually will not be one option that is mathematically a slam dunk over the other.  As a borrower, you need to take an honest look at your finances, think about the different things that can happen to you and the market, and then make a decision once you have reviewed all the data you can.  Most of the time there is no right or wrong answer to this question.