Choosing the best interest rate when refinancing your student loan can be tricky.
Variable rates are often lower. But are they a good deal? Is it better to go with a fixed interest rate for long-term predictability?
Why does it matter so much?
Each of these rates can have a very different impact on the amount you pay each month. Let’s dig and talk about what you need to know.
What’s the difference between fixed and variable interest rates?
A major source of confusion for borrowers is the difference between a fixed rate and a variable rate. And like any financial matter, there are a lot of moving parts.
Fixed rate loans have a set interest rate that you will pay throughout the duration of the loan. The rate is guaranteed to remain stable, which results in the same loan payment amount every month until your loan is paid in full.
A variable rate on the other hand, will fluctuate depending on either the Prime Lending rate or LIBOR rate. A Prime Lending rate is an interest rate at which banks lend to favored customers. A LIBOR rate is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
This fluctuation can yield a different loan payment each time the interest rate changes.
A variable rate may be enticing if you’re looking to decrease monthly payments. But even though a variable rate may start out lower than a fixed rate, there’s no guarantee that you will continue to benefit from a lower rate throughout the life of your loan.
In fact, these lower rates can (and often do) rise above the fixed rate over time. For instance, a variable rate may be 3% early in the year, but rise to 4% or more later in the same year.
As the rates rise, it’s possible that you could find yourself in the position of no longer being able to afford your monthly payment. This could lead to you being in worse financial shape than before you refinanced.
But that doesn’t mean you should avoid variable interest rates altogether.
When is a variable interest rate is a good choice?
Variable interest rates are typically good for short-term loans or loans you can pay off fast. If you don’t have much left to repay on your student loan, or if you have a plan that will allow you to repay quickly, then a variable interest rate may be a good option.
For instance, a variable rate on a 10-year loan might range from 2.74% to 8.24%, versus a fixed rate 10-year loan at 3.18% to 8.33%. If you intend to pay your loan off in the next few years, it might be worth taking a look at a variable rate option.
Plus, many lenders offer a cap on their variable rates to make them more attractive and to provide some security to borrowers. However, it’s important to note that sometimes the cap is so high that the initial savings of a lower rate are lost on when interest rates rise.
That’s why it’s a good idea to ask your potential lender what their current cap is on variable rates. Learn about other student loan refinancing terms that could impact your decision.
When a fixed interest rate is a good choice
For most people, a fixed rate is preferred. It’s easier to budget for predictable payment amounts and there are no surprises. If you intend to pay the debt over a long period of time, it is wise to go with a fixed rate.
A fixed rate loan offers the certainty that your interest rate will be stable and unchanging over the full life of your loan. This is a good option if you believe interest rates are likely to increase over time.
To find out how much you could save from refinancing, check out our Student Loan Refinancing Calculator.