Whether you’re borrowing or refinancing student loans, you could face the choice between a fixed and variable rate. Your lender may even have a hybrid option that is part fixed rate and part variable.
If you’re not sure about the differences between fixed interest rate and variable loans, or why you may want one over another, here’s a short guide to get you started.
How do fixed rates work?
Getting a fixed rate means you lock in one interest rate when you get your loan, and that rate doesn’t change over time. Your monthly payment is also the same throughout the life of the loan. Your final payment on a 10-year loan, for example, will be the same as your first payment (assuming you do not make any extra payments along the way, which could reduce what you owe each month).
When you see a fixed rate alongside an APR (Annual Percentage Rate), don’t worry: the rate is still fixed. The APR is the interest rate that incorporates other fees your loan may include. The most common fee is an origination fee, usually charged as a percentage of your total loan balance. The APR is meant to help borrowers understand the total cost of a particular loan. Comparing the APRs of different loans is therefore the best way to measure two different fixed-rate loan options.
How do variable rates work?
A variable rate is an interest rate that changes over time based on the financial markets. The rates can be susceptible to change on a monthly basis or whatever time frame a lender specifies. Lenders typically combine a common market benchmark or measurement, like one-month LIBOR (which stands for London Interbank Offered Rate and is based on rates banks in London offer each other for inter-bank deposits), plus a “spread,” which AllBusiness defines as “the difference between the interest rate charged on a bank loan and the lender’s cost of funds to create a variable rate.” So, if your credit is good enough to borrow a loan with a 4 percent interest rate, but you accept a loan with a 5 percent interest rate, the spread of that loan is 1 percent.
Typically, lenders will combine the spread of your loan with a market measurement to come up with your interest rate for that month. So, if one-month LIBOR is at 0.15 percent for the month, and the spread on your loan is 3 percent, your rate is 3.15 percent for the month. (Remember to always check the loan’s APR to understand the impact of any fees in conjunction with this rate.)
This means your monthly payments can go up, down, or stay the same depending on what happens in the markets. Variable-rate loans may have caps, or maximum rates, as a protection for borrowers in the event that rates skyrocket (a great feature to ask about when you’re considering a variable-rate loan option).
Why would you want a fixed versus variable rate?
When deciding between a fixed or variable rate student loan, be sure to weigh the pros and cons of each option as well as circumstances that are unique to your situation. Meredith Ruble, CFO The Noodle Companies
Essentially, fixed and variable rates offer tradeoffs based on your appetite for the risk of changing interest rates. Variable-rate loans tend to come with lower rates than fixed loans, which is basically financial compensation for taking on the risk of variable rates changing. Meanwhile, fixed rates offer you the advantage of knowing exactly what your rate is, and what your rate will be, but your interest rate will be a bit higher than a variable alternative.
Are there any other options?
A middle ground between the two is a hybrid rate, often known as a fixed-to-float rate. While they’re more common in the mortgage lending space than in the student loan industry, a few lenders like CommonBond do offer hybrid options. This type of rate gives you the benefit of a fixed rate for some part of your loan — say, the first five years of a 10-year loan term — before switching to a variable rate. You’ll benefit from a slightly lower fixed rate than on a fully fixed loan, and if you can prepay during the early years, you’ll also be able to reduce your exposure to variable rates on the back half of your loan.