Variable Interest Rate vs. Fixed-Rate Student Loans
When you take out a student loan, the most important part of the loan is the interest rate that you are charged. The interest rate determines the size of your monthly payment and how much you’ll pay over the life of the loan. A high interest rate translates to higher payments and a higher cost. A low interest rate means you’ll save money.
Though interest rates are incredibly important, they can also be very difficult to fully understand. We break down the complicated parts of interest rates and broken those terms down into easy to understand pieces that will help you tackle your student loans.
When You Borrow, You Pay Interest
Put simply, interest is the amount that you pay for the privilege of borrowing money. The exact interest charge is calculated based on the interest rate. The higher the rate, the more you are paying to borrow money.
What that means is if you take two loans with the same term and for the same amount, the one with the higher interest rate will cost more. That means you’ll pay more on that loan each month.
So how does interest actually work? Interest is calculated each month based on the total unpaid portion of your loan. If you borrowed $10,000 and have paid the balance down to $5,000, that month’s interest charge will be calculated based on the $5,000 balance.
Interest rates are quoted as a percentage rate per year. For example, you could have a student loan with an interest rate of 5%. If the loan is for $10,000, and make no payments for the whole year, at the end of the year, you’ll owe $10,500. Your balance will have increased by 5%. If the loan was for just $5,000, your balance would have increased by $250. The more you owe, the more interest you pay, even with the same interest rate.
This is, of course, a simplification that ignores the inevitable fees for non-payment, and the fact that interest compounds: you are charged interest on the interest.
How Is Your Interest Rate Determined?
The interest rate on loans is based on the risk for the lender. Lenders charge more interest on loans with higher risk. If a lender thinks you might not pay back a loan, they’ll charge you more so that they earn their investment back more quickly.
How do lenders gauge their risk? Your credit score is the primary way that lenders determine how risky it would be to lend to you. A high credit score means a lower interest rate. A lower credit score equals a higher interest rate.
There are two types of interest rates that can be applied to loans: fixed interest rates and variable interest rates.
Fixed Interest Rates
Fixed interest rates are straightforward. When you take out your loan, you’ll know what the interest rate will be. It will not change over the life of the loan. It is fixed where it is. That means you know exactly how much you’ll pay each month, and exactly how much you’ll pay over the life of the loan.
Consider this example:
You borrow $20,000 for 5 years at a rate of 6%. You’ll know that you’ll pay $386.66 each month, for the next 60 months. That means you’ll pay $23,199.36 over the life of the loan.
Federal Direct student loans always have a fixed interest rate. There is no option to get a variable rate loan. Congress sets the rate for new federal student loans, which applies to loans taken out each year. Once the loan is open, the rate will not change, but if you take out a new loan for each year of college, each loan might have a different fixed rate.
Variable Interest Rates
Variable interest rates are more complicated than fixed rates because they live up to their name: variable. Variable rate student loans can have their interest rate change, which affects the size of your monthly payment and how much you’ll pay over the life of the loan. Although federal student loans only offer fixed interest rates, private student loans offer variable rates. However, you do have the option to choose a fixed interest rate or a variable interest rate for a private student loan.
What causes the rate on your loan to change?
Usually, a variable interest rate is tied to a benchmark.
One of the most commonly used benchmarks is the London Interbank Offered Rate, otherwise known as the LIBOR index. This is the average of the interest rates each of the leading banks in London estimates it would need to pay should they need to borrow from another London bank. You can find out what the LIBOR index might be for your student loan from The Wall Street Journal.
When governmental policies cause money to be easily available to banks, they won’t need to pay much to borrow, so the LIBOR drops. When economic policy is tight and cash is scarce, the LIBOR increases.
Variable rate student loans will often charge a rate equal to the LIBOR plus a set amount, such as “LIBOR plus 4%.” Your lender will disclose what the set interest rate is, before the LIBOR index is added, for your student loan in your loan agreement disclosure or somewhere in the fine print on their site.
Variable rate loans tend to charge less interest than fixed-rate loans. They also have the advantage that the interest rate could decrease, making the loan even cheaper. Still, variable rate loans are dangerous. If rates increase significantly, you could be stuck with a monthly payment you’re not able to pay.
We've put together a table to give you an idea of what fixed interest rates vs. variable interest rates might look like from some popular student loan lenders. We've also researched out the maximum variable interest rate a lender can change, regardless of how high the LIBOR index might be. Just remember, that your interest rate is determined based off of your own financial history, credit score, income, and other factors, and lenders may change their interest rates at any time.
Fixed Interest Rates vs. Variable Interest Rates From Top Student Loan Lenders
|Lender||Fixed Interest Rates||Variable Interest Rates||Maximum Variable Interest Rate|
|Discover||6.49% to 11.99%||4.62% to 10.62%||18%|
|Citizen's Bank||6.24% to 11.99%||3.96% to 11.56%||21%|
|PNC||6.49% to 12.99%||4.58% to 11.53%||18%|
|CommonBond||3.18% to 7.25%*||2.60% to 7.10%*||8.99% (for 5-year term) or 9.99% (for all other terms)|
|Wells Fargo||6.24%* to 12.39%||4.25%* to 10.99%*||18%|
|Sallie Mae||5.75% to 12.86%||5.13% to 11.50%||25%|
|SunTrust||4.75% to 11.50%*||3.50% to 10.55%*||18%|
*Rates include when you enroll in automatic payments from each bank - usually a .25% decrease in interest rate
Is One Rate Better Than The Other?
Which type of loan is better for your is very dependent on your situation. More often than not, you may not have a choice in which type of student loan you can take on.
The major benefit of a variable-rate student loan: Variable rate loans may offer lower rates. If market interest rates increase, you’ll wind up paying more - BUT on the flip side, if rates go down, you could save even more.
The major benefit of a fixed-rate student loan: Fixed rate loans offer certainty. You’ll never have to worry about your payment changing. They also aren’t affected by increasing rates.
To choose the right type of loan, you have to consider both your current and your future financial situations. If you don’t anticipate trouble paying the loan if rates increase, and think rates might actually decrease, a variable rate loan is a good choice. If you value stability, a fixed rate loan is the right choice.
Other benefits with federal student loans
Federal student loans only have fixed rates, which you may not like. But, note that they make it easier to qualify for deferment and forbearance programs. They can be helpful if you need temporary financial relief from your student loan debt.
Compare Deferment vs. Forbearance
Also, federal loans are eligible for income-driven repayment and student loan forgiveness programs, which may not only help you maintain your monthly payments, but could even wipe out your debt altogether.
Pros & Cons of IDR Programs
Refinancing Lets You Change Your Interest Type
One thing to remember is that you can change from a variable rate loan to a fixed rate loan, or vice versa, by refinancing. You’ll have to pay the fees to refinance and deal with the interest market at the time of refinancing, but if your situation changes it is possible to change your loan.
The take away from all this is that there is no universally right choice when it comes to deciding between a fixed and variable rate loan. Which choice is correct depends on your situation. Variable rate loans can result in a lower cost loan but bring risk. A fixed rate loan offers significant stability.