When faced with the need to find funds to close the gap between college costs and available financial aid, many students and their families turn to private student loans. One of the first choices a family looking at a private loan needs to make may be choosing between a variable and a fixed interest rate. Which is best? The answer: it depends.
First, you should know that variable rates are typically lower than fixed rates. Why? Nobody can predict the future accurately. Because a bank is in the business of making money they must always consider the risk of lending money. One of those risks is called “interest rate risk” – the risk that in the future the bank will need to pay a higher interest rate to its lender for the money it has lent to you. A fixed rate loan, especially one with a long term like a mortgage or a student loan, offers a rate that anticipates higher future rates.
On the other hand, a variable rate loan is usually presented to the consumer as a base rate (such as Prime or LIBOR) plus a “margin”. This assures that the bank will always earn money because when the rate the bank pays to borrow money changes, the base rate will change in the same direction, but the bank will always have a consistent “margin” – that extra percentage they add on to the base. Banks love predictable cash flows – hence, the lower rate for variable rate loans. But, there is a risk to you – what if the base rate increases significantly over time? Your payments will increase to a level that may be higher than one you are able to afford.
So, in the end, the choice between a fixed and variable interest rate is a personal choice based mainly on the borrower’s long-term and short-term goals. What should you consider when weighing the decision between variable and fixed rate loans? Experts say that the answers to just a few questions can help make the decision easier.
Do you believe interest rates will increase significantly over time?
To answer that question you may need to do some research or consult with an expert, but, in general, if you imagine interest rates will increase beyond the offered fixed rate (and stay there) over the term of your loan (around 15 years if you include the time in school), you may want a fixed rate.
Do you imagine being able to pay off the loan faster than the repayment schedule assumes because of an expected windfall in the future or a very high-paying job?
In that case, a variable rate may work for you.
Do you like consistency so you can more easily create a budget?
A fixed rate is the one for you – you won’t see any gains when interest rates drop but you also won’t see any losses when they increase. And you will know exactly what your payment will be for all 120 months of your repayment term.
Do you want to start repaying your loan immediately (which is a good idea)?
Then a variable rate may be best for you as the monthly payments will generally start off lower than a fixed rate loan.
No matter which loan type you select you can choose either type for the next loan. If you follow the old saying of not putting all your eggs in one basket (what financial planners call “diversifying your risk”), you may want to consider taking out some fixed rate and some variable rate loans over the course of your college career.
By: Iowa Student Loan