If you’re applying for student loans, you may be faced with a dilemma: should you choose a fixed interest rate or a variable interest rate?
Depending on your financial situation, repayment strategy, and risk tolerance, one may be better than the other. Understanding fixed vs. variable rates can give you a better idea of which one would be best for you.
Fixed rate vs. variable rate: What’s the difference?
Fixed and variable interest rates aren’t unique to student loans. You may see both types of interest rates with mortgage loans, credit cards, personal loans, and more.
In some cases, it may not matter which option you choose. For example, if you pay your credit card bill on time and in full every month, you won’t pay any interest, regardless of which type of rate the card has. If the loan has a relatively short term, such as one or two years, the difference may be small.
However, with student loans, where repayment terms are often 10 years or longer, it’s essential that you pick the right type of rate for your situation.
Since July 2006, all federal student loans have fixed interest rates, so you don’t need to compare a fixed vs. variable rate option.
With private student loans, you may be able to choose between a fixed and variable rate, depending on the lender. Here’s how a fixed rate vs. variable rate loan works.
Fixed interest rates
As the term suggests, a fixed interest rate will stay the same (or be —fixed”) for the life of the loan. This means that your monthly payment will also stay the same unless you’re on an income-driven repayment plan that sets your payment as a percentage of your income, or a graduated repayment plan that increases over time.
While a fixed interest rate won’t change while you’re repaying your debt, it will be higher than the initial rate on a variable-rate loan. This is because the lender is taking on more risk with a fixed rate. If interest rates go up over time, the lender is still stuck charging you the lower rate you agreed upon.
Variable interest rates
Unlike fixed interest rates, variable rates can fluctuate over the life of your loan. The interest rate will typically change on a monthly, quarterly or annual basis. Variable rates are usually calculated based on the London Interbank Offered Rate, called LIBOR for short. This rate is a market benchmark for many different types of loans and credit cards globally.
If the LIBOR falls, so will the rate on your loan. But if the LIBOR increases, your interest rate — and monthly payment — will go up with it.
Variable interest rates typically start out lower than fixed interest rates because the lender is shifting some of the interest rate risk to you. If the rate goes up, you’re the one who will end up paying for it via higher monthly payments.
Variable vs. fixed rate: Pros and cons
At first glance, you might be drawn to one option over the other. Before you commit, it’s important to consider both the benefits and drawbacks of a fixed rate vs. variable rate.
Fixed rates: Benefits and drawbacks
The primary benefit of a fixed interest rate is the certainty it provides. You never have to wonder if your monthly payment is going to go up because market interest rates have spiked. You also know exactly how much you’re going to pay in interest on your loans, and you can easily determine how much money you’ll save by paying down your debt early.
On the flip side, fixed interest rates start off higher than variable interest rates, and there is a possibility that market rates will go down instead of up. Depending on the situation, a fixed rate could cost you more up front and over the life of the loan.
Variable rates: Benefits and drawbacks
The principal benefit of a variable interest rate is that you’ll likely pay less than you would with a fixed-rate loan during the first interest rate period, and potentially after that if market rates decrease.
In contrast, you’re essentially at the mercy of the market as it changes over time. Since it’s impossible to predict which direction market rates will go over time, variable rates can be more stressful, and more expensive.
Variable vs. fixed rate: Which should you choose?
Choosing between a variable vs. fixed rate depends on three factors: your repayment strategy, your financial situation and your risk tolerance.
For example, if your repayment term is several years and you don’t know if you’re going to be able to pay them off early, you may be better off with the stability that comes with a fixed interest rate.
A fixed interest rate is also generally a better idea if your budget can’t handle the potential of a higher monthly payment down the road.
However, if you have a relatively short repayment term or have a long repayment term but plan to pay them down faster over the next few years, a variable interest rate may be a better option. Not only will your interest rate start out lower, saving you money, but even if the rate does go up over the next couple of years, the increase may be low enough that you’ll still save money over a fixed rate.
Just remember that if you choose a variable rate, your budget needs to be able to handle potentially higher payments in the future.
As you consider both options, also think about your risk tolerance regarding market interest rates. If the idea of your monthly payment going up over time is anxiety-inducing for you, the potential savings may not be worth the stress. But if you and your budget can handle interest rates not going your way, a variable rate could be more appealing.
The bottom line
If you’re applying for a private student loan, take some time to think about how you want your loan’s interest rate to be structured. Neither option is inherently better than the other, and what works for a friend or family member might not work for you.
The better you understand your financial situation, goals, and risk tolerance, the easier it will be to pick the right option.