When it comes to student loan interest rates, there are two basic options. Option one is a fixed rate loan, where the interest rate does not change over the live of the loan. Option two is a variable rate loan.
The advantage with variable rate loans is that the interest rates start much lower than they do on a fixed rate loan. For example, a lender like SoFi is currently offering student loan refinance rates of 3.50% for fixed rate loans, but their variable rate loan is currently 2.23%. The risk with the variable rate loan is that it can go up, and in the long run cost more than the fixed rate loan.
How is the variable interest rate determined?
Most lenders will tie the interest rate to an index rate. As an example, many lenders use the LIBOR rate as the index rate. The LIBOR rate is the interest rates that banks are charged to borrow from other banks.
This means that as a borrower, your interest rate will be defined as LIBOR + a certain percent. Suppose your interest rate is LIBOR plus 2%. If the applicable LIBOR rate climbs up to 3%, your student loan interest rate will be 5%.
What this means is that as the index rate goes up or down, your student loan interest rate will likewise go up or down.
If you are considering a variable rate loan, find out what index the rate is tied to. Once you know the index that will either raise or lower your interest rates, you can look at historic rates for that index to get an idea of where it can go.
How often does the variable interest rate change?
This will be a specific term of your student loan agreement and something the lender should easily be able to tell you. It could be monthly, quarterly, or yearly.
What is the highest a variable rate loan can go?
With many loans there is no maximum. As the index rate rises, your student loan interest rate also goes up.
However, some lenders offer an interest rate cap. This is typically set at a fairly high rate (think over 10%). That being said, this is a nice feature because as a borrower you know your worst case scenario.
Is a variable rate loan a good choice for me?
There are two major factors to consider when making this decision.
First, are you a person who is willing to accept risk. If you are a risk taker, you might be more comfortable borrowing a variable rate loan. If you would have taken out such a loan 5 years ago, you would be way ahead of those who took out fixed rate loans. If you cannot accept the risk that your interest rate could increase, a fixed rate loan might be a better option.
Second, it is important to consider how long your loan will be in repayment. If you plan on having everything paid off in the next 3-5 years, a variable rate loan might be less risky because interest rates are not likely to change dramatically in such a short timeframe. However, if you will be paying off the loan for the next 20 years, a variable rate loan can be dangerous. Interest rates could look dramatically different by the year 2036.