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 life 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. The risk with the variable-rate loan is that it can go up. Generally speaking, the longer the loan repayment length, the more dangerous it is to go with a variable-rate loan.
How is the variable interest rate determined?
Most lenders will tie the interest rate to an index rate. The index rate is the rate that will dictate the movement of a loan. As the index rate goes up or down, the interest rate of the loan will also go up or down.
As an example, many lenders use the LIBOR rate as the index rate. The LIBOR rate is the interest rate that banks are charged to borrow from other banks.
This means that as a borrower, your interest rate will be defined as LIBOR plus 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%.
If you are considering a variable-rate loan, find out what index the rate follows. Once you know the index that will either raise or lower your interest rates, you can look at a rate history for that particular index to get an idea of where it might go.
How often does the variable interest rate change?
The timing of rate changes 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 it provides the borrower an idea of the worst-case scenario.
How much can I save by going with a variable-rate loan?
The potential savings offered by a variable-rate loan will depend upon the lender selected and the repayment length chosen.
Our most recent review of the best refinance rates shows that borrowers on a 5-year loan can get an interest rate of around 2%, while those who opt for a fixed-rate loan can get an interest rate of around 3%. However, not all lenders offer the same discount for selecting a variable-rate loan. At times we have seen some lenders offer the same starting rate in both the variable and fixed-rate category.
For private student loan borrowers, the discount for selecting a variable-rate loan is about the same as the discount in a refinance.
Ultimately, the only way to know for certain how much one might save by selecting a variable-rate loan is to shop around for both loan types and compare the potential costs.
Is a variable-rate loan a good choice for me?
There are two major factors to consider when making this decision.
First, is your willingness to accept risk. If you are a risk-taker, you might be more comfortable borrowing a variable rate loan. If you had taken out a loan five 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 2040.