Student loan decisions will impact your personal finances for years.
Assessing the pros and cons of fixed- and variable-rate student loans is important.
Here’s a user-friendly guide to fixed-rate and variable-rate student loans.
Student loan decisions will impact your personal finances for years, and borrowers must consider several factors. Here’s a user-friendly guide to fixed-rate and variable-rate student loans. This information will help you make the right financial decision for your situation.
Fixed Rate vs. Variable Rate Loans
The interest rate on a fixed-rate student loan does not change over the life of the loan. A fixed interest rate means that your payments stay the same, making it easier to budget for student loan payments.
On the other hand, the interest rate on a variable-rate student loan may change as interest rates change. Your monthly payments may increase or decrease depending on changes in interest rates. Budgeting for student loan payments is more difficult if you have a variable-rate student loan.
|Fixed Rate Loans
|Variable Rate Loans
|Fixed at X% throughout the loan term.
|Fluctuates over the loan period. Starts at 3% but could rise to 5% or fall to 2.5%.
|Predictable and remains the same, which makes budgeting easier.
|It can vary, sometimes significantly, with interest rate changes, affecting budget planning.
|Less flexible; breaking a fixed-rate loan can incur costs.
|More flexible, often allowing for overpayments or changes without significant penalties.
|Lower risk as rates are locked in, protecting from interest rate rises.
|Higher risk, as rates can increase, but there’s also the potential benefit of rates decreasing.
|Initial Interest Rates
|Typically higher than the initial rates of variable loans.
|Often lower initially but can increase over time.
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The Pros and Cons of Fixed Rate Loans
A fixed interest rate keeps your student loan payments the same over the life of the loan. Budgeting student loan payments is easier when the monthly payment amounts are fixed. If your monthly payment is $250, you can plan for the same payment each month until the loan is paid off.
Calculating your total loan payments
If you know the variables, you can use a loan calculator to determine the total cost of your loan. Assume that you have a 5% loan with a balance of $20,000, and the loan term is 10 years.
Using the loan calculator, your monthly payment is fixed at $212.13, and your total cost is $25,455.22. You will repay $20,000, plus $5,455.22 in interest over the life of the loan.
Understanding Fixed Student Loan Rates
Most student loans are now issued through the US Department of Education. The current interest rate for undergraduate direct loans first disbursed on or after July 1st, 2023 and before July 1st, 2024 is 5.50%. Rates are higher for students in graduate school.
To give you some idea about payments, a 10-year, 5.5% loan for $20,000 generates a $217.05 monthly payment, and a 10-year, 5.5% loan for $15,000 generates a $162.79 monthly payment.
Once you take out a loan, the interest rate doesn’t change. However, the interest rates may differ if you take out a new loan each year you’re in school.
Private lenders also provide fixed-rate student loans, but the interest rate charged may be much higher than loans through the Department of Education. Your credit score will help determine the interest rate offered when choosing education financing through a lender.
Fixed Student Loan Rates: Drawbacks
There are disadvantages to fixed-rate loans. When you take out the loan, the interest rate may be higher than a variable rate. If interest rates decline, your loan repayment schedule doesn’t change. Variable-rate loan payments decline when interest rates decrease.
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Variable Rate Loans: Pros and Cons
A variable interest rate loan may start with a lower interest rate than a fixed rate loan, creating a lower monthly payment. If interest rates decline and remain lower, your monthly payments will also be lower. You can repay your student loan debt faster when interest rates are lower.
The Impact of Interest Rate Changes
- Variable-rate loan payments increase: If interest rates rise and remain higher, your monthly payments will be higher. Budgeting for student loan payments will be more difficult, and paying off your loan will require more of your monthly income.
- The number of years remaining on your loan is also a factor: The more years remaining, the bigger the impact of a change in interest rates. If interest rates increase, a 10-year loan is impacted more than a 5-year loan. You pay far more interest over 10 years than 5 years.
- Interest rate decrease: It makes a big difference financially if you can save by paying less interest over 10 years vs. 5 years. Borrowers who plan on repaying loans over a shorter period of time (5 years instead of 10 years, for example) are less impacted when variable loan interest rates increase.
How Variable Rate Loans are Issued
1. Identify Private Lenders:
- Understand that only private lenders offer variable-rate loans.
- Note that these differ from fixed-rate loans offered by the Department of Education.
2. Be Aware of Interest Rate Differences:
- Recognize that private lenders may charge higher interest rates than federal government loans.
3. Understand How Variable Rates Work:
- Know that variable rates change as overall interest rates fluctuate.
- Your loan rate may change monthly or quarterly.
4. Learn About Rate Indexes:
- Many lenders base their interest rates on indexes like the Secured Overnight Financing Rate (SOFR) or the US Prime Lending Rate.
5. Inquire About Interest Rate Caps:
- When contacting a private lender, ask if they offer a cap on the highest interest rate you can be charged.
6. Consider an Example Scenario:
- For instance, calculate the implications if the current variable rate is 7% and the lender caps the rate at 10%.
- If borrowing $14,000 for 10 years, use a loan calculator to determine the maximum monthly payment at a 10% interest rate.
7. Assess Affordability:
- Determine if you can afford the monthly payment at the maximum interest rate.
- If not, consider opting for a fixed-rate loan to ensure a manageable, fixed monthly payment.
8. Understand the Consequences of Late Payments:
- Be aware that late or missed student loan payments will negatively impact your credit score.
- Understand that this can make borrowing more difficult in the future.
Evaluating Risk Tolerance
Choosing a variable-rate loan creates some financial risk because your loan payments will increase if interest rates increase. Consider your risk tolerance and if you’re comfortable with taking these risks.
To explain this concept, refer to the 10-year, 5% loan with a balance of $20,000 that was explained above. The monthly payment is fixed at $212.13, and you will repay $20,000 plus $5,455.22 in interest over the life of the loan.
Now assume that the loan has a variable rate, and that 2 years later the rate increases to 9%. The principal remaining after two years is $16,897.83.
Using the same loan calculator, your monthly payment for the remaining 8 years is $247.54, and the total interest you would pay is $6,867.27 You now owe more interest over 8 years ($6,867.27) than you owed over 10 years ($5,455.22).
Finally, the added risk is that your variable rate could go even higher.
Considering Student Loan Refinancing
Borrowers can refinance student loans with your original or a new lender. Remember that refinancing a loan may require a loan origination fee paid to the lender to process your loan application.
You cannot refinance a US government fixed-rate direct loan with a variable-rate loan through the Department of Education. However, you can refinance a US government fixed-rate direct loan for a variable loan offered by a private lender.
If you refinance with a private lender, you cannot take out additional loans through the federal government. If you don’t finish your course of study for several years, you may want to keep the option of taking out more federal student loans. The federal government offers some borrowers loan forgiveness and other benefits that may be attractive.
The Bottom Line
Your student loan decisions have a big impact on your long-term finances. Assessing the pros and cons of fixed- and variable-rate student loans is important. Create a budget that includes monthly student loan payments, ask your lender questions about your loan, and stay informed.
How can my variable-rate student loan payments change over the life of the loan?
Higher interest rates will increase your monthly payments, and interest rate declines will reduce your monthly payments.
Can I get a variable-rate loan through the federal government?
Variable-rate loans are not offered by the Department of Education. You must go through a private lender.
Can I refinance a US government fixed-rate direct loan with a variable-rate loan through the Department of Education?
No, you cannot refinance a US government fixed-rate direct loan with a variable-rate loan through the Department of Education. However, you can refinance a US government fixed-rate direct loan with a variable loan offered by a private lender.