Federal student loan interest rates are pretty easy to understand. No matter what your credit rating is, you’ll get the same rate for the same type of loan for a specific school year. For instance, for the 2015-2016 school year, interest rates for federal student loans issued directly to students were 4.29 percent for undergraduates and 5.84 percent for loans to graduate and professional students. The rate was 6.84 percent to parents. Graduates and professionals who want to borrow beyond the limit available at 5.84 percent can borrow additional funds at the 6.84 percent rate.
Private student loans are a bit different. Since credit history and market variances are factors in interest rates, rates can start as low as 2 percent. Rates can, at times, be cheaper than federal student loans and are worth comparing.
Compare private loans to other bank loans
Like mortgages, there are options for both variable- and fixed-rate loans. With a variable-rate loan, the interest rate can change based on what happens in the general economy. This means payments over the course of months or years can rise quite a bit--sometimes several hundred dollars monthly on a large loan. Payments can drop as well.
Why would anyone opt for a variable rate? Maybe the loan is borrowed for a short period of time. Or rates are expected to drop. For example, let’s say the best interest rate on private student loans currently offered is 4 percent for a fixed-rate loan and 3.5 percent for a variable-rate loan. If the borrower knows repayment will be complete in two years, the better option may be the 3.5 percent interest rate. It's a risk, though.
Make sure the private loan interest is affordable for you
On the other hand, let’s say rates are currently at 8 percent for a fixed-rate loan and 7.5 percent on a variable-rate loan. We’ll also assume a $10,000 loan. Analysts predict a rate drop of 2 percent in the next few months. Borrowing at a variable rate can be risky. What if rates increase 6 percent? The point is you always want to be able to afford your payment. Variable rates can make payments unaffordable if you are unprepared for potential rate hikes. If you're interest rate becomes unmanageable down the road you can figure when to refinance your student loans to possibly get a lower interest rate.
Always compare all your options from federal loans to fixed- or variable-rate private loans. Then choose the option that works best for you. If you're only borrowing for a year, the best option may be none of the above, especially if your child's school offers a tuition repayment plan.