The choice between a fixed rate and a variable rate isn’t overly difficult; it comes down to a few key distinctions, including economic influences and your student loan terms.
Fixed vs. Variable Rates
Conventional wisdom is the lower the interest rate, the better the deal. This does not take into account the way interest rate indices change over time, however.
Financial advisors usually recommend a fixed rate over a variable rate; fixed rates aid financial planning and avoid the risk of a spike in interest rate indices.
There are few conditions under which a financial advisor would recommend adopting a variable rate. Such situations may include a low-balance, short-term loan under certain economic circumstances; this is due to how lenders determine interest rates – in particular, how they use their preferred interest rate index.
Variable Interest Rates Explained
Variable interest rates tend to start a little lower than fixed rates, but that doesn’t necessarily mean you’ll save more. Private lenders set variable rates at the time of the loan’s origination. Variable rates then change according to interest rate indices, such as the London Interbank Offered Rate (LIBOR).
Lenders typically adjust their variable rates either monthly or quarterly based on which index they use. Interest rate indices experience similar peaks and valleys since they are influenced by similar economic factors.
Between 2003 and 2007, the 1-month LIBOR annual average increased 334%, from 1.21 to 5.25. Then, from 2007 to 2009, the annual average declined 93.7%, down to 0.33 or 72.7% lower than 2003’s average annual rate. During this same 2003 to 2009 period, the Bank Prime Loan Rate increased 95.4% and subsequently fell 59.6% or 21.1% lower than its 2003 average annual rate.
Some borrowers with shorter loan terms still opt for a variable rate; from 2009 to 2015, interest rates were stable and historically low. If you do select a variable rate and it later increases significantly, you may have the option to refinance again at a fixed rate.
Note that interest rate indices have been reset to historic lows in the wake of COVID-19. The Federal Reserve has disclosed plans to raise interest rates in coming months.
Fixed Interest Rates Explained
Fixed interest rates are generally recommended because they remain the same for the life of the loan. A steady rate lets borrowers determine exactly how much interest they’ll pay and when (provided they make all payments in full and on time).
A fixed rate not only allows you to predict how much you’ll ultimately pay, but it also lets you know exactly how much you’ll save by refinancing. In essence, fixed rates are safer and more conservative. This is ideal for most student refinance loans.
All federal student loans use a fixed rate only. It is possible to refinance federal loans at a variable rate with a private lender, but this is generally not recommended. In addition to the potential for a rate spike, refinancing also invalidates any special protections or benefits for which federal student loans are eligible.