Whether you’re borrowing a private student loan or refinancing your student loans, you have a choice to make. Do you go with a variable or a fixed interest rate loan?
Variable student loan interest rates can change multiple times per year as the market changes. Many private student loan lenders set rates based on the London Interbank Offered Rate (LIBOR). To determine your variable rate, the bank takes the LIBOR plus a margin based on your credit evaluation.
Why would anyone go with a variable rate student loan? Variable interest rates are risky, so creditors incentivize you to choose a variable rate over a fixed rate by offering a low initial rate.
Don’t let that low initial rate suck you in, though. Choosing a variable rate can make sense in some situations, but you need to be careful. Below, we’ll discuss four things to watch out for with variable student loan interest rates.
4 Things to Watch Out for With Variable Student Loan Interest Rates
Advertised rates can be misleading
When you look at a lender’s advertised rates, the variable rate ranges are almost always lower than the fixed-rate ranges. Why? Because borrowing a variable rate loan is riskier. Your reward for taking the risk is starting out at a lower rate.
Of course, that doesn’t mean that a variable interest rate is always lower than the fixed interest rate. Every lender uses its own criteria when determining what interest rate you qualify for. It’s possible that one lender could offer you a 3.5% variable interest rate while another offers you a 3% fixed interest rate.
Even if you’re okay with the risk associated with variable interest rate loans, don’t assume that the variable rate will be lower. Instead, ask for fixed and variable rate quotes from every lender you’re considering. Those numbers—not the advertised rates—are what actually matter.
The best deals are often tied to the shortest loan terms
Variable interest rates often work out better for borrowers interested in a short repayment term. Why? Because repaying your loan over five years rather than 10 or more gives the rate fewer opportunities to change. Plus, many lenders only offer their best rates to borrowers who choose a short loan term.
For example, CommonBond’s lowest variable rate is only available to borrowers who choose a five-year repayment term.
Also, keep in mind that a five-year loan term means larger monthly payments. If you’re offered a low rate on a five-year loan, use a loan repayment calculator to see what you’ll owe each month. Make sure your budget can handle it.
You can’t predict how much rates will change
With a variable rate loan product, it’s safe to say rates will change over the life of the loan. However, there’s no way to predict just how much they’ll change.
A rate change affects your payment because your monthly payment is based on the principal and accruing interest. If you’re living paycheck to paycheck, an increase could strain your finances.
Historically, LIBOR rates fluctuate substantially. You can see LIBOR rates over the years on MacroTrends. Looking at historical rates gives you an idea of just how much the rate could fluctuate month to month and year to year.
Before borrowing a variable interest rate loan, make sure you know how the bank or financial institution sets its rates. Ask how often rates change. Some lenders change rates monthly. Others do it quarterly or annually. Find out what the rate cap is for the loan. A rate cap is the highest the lender can raise the interest rate to.
If you borrow student loans with a shorter repayment plan or if your lender only changes rates annually, there are fewer opportunities for that rate to change. That lowers the risk of borrowing quite a bit compared to a longer-term loan or a lender who changes rates every few months.
You could get stuck with the variable rate loan
Some student loan borrowers go with a variable rate loan because the initial interest rate is too low to pass up. They bank on paying off the loan quickly before the interest rate can spike. Or they bank on refinancing their student loans if the rate increases.
Unfortunately, this can be a risky strategy. What started out as a low-interest variable student loan could turn into a high-interest rate variable student loan that you can’t afford to pay.
You might face unexpected financial circumstances like medical debt or job loss. You might not graduate from college—something that happens to 40% of college students. Any of those situations would make it harder for you to pay off your loan early or to refinance to a lower rate.
Carefully consider that possibility when deciding between fixed and variable interest rate student loans.
Is a Variable Rate Student Loan Right For You?
Borrowing student loans might be the only way that you can afford to go to college, but borrowing student loans also makes college more expensive. Your interest rate determines just how much more expensive.
Right now, student loan rates are at an all-time low because of actions the Federal Reserve took in response to the coronavirus. The Federal Reserve set the federal funds rate to 0 to 0.25 percent, reaffirming on November 5, 2020, that it will stay there until labor market conditions improve. Private lenders account for this rate when setting their own rates.
Variable-rate student loans are always risky, but they’re arguably riskier when rates are this low. The only direction the rates can go is up. Fixed interest rate student loans are also at low right now, so although they might be higher than a variable interest rate loan, they’re still a lot lower than they were in previous years.
In fact, if you did recently borrow a variable or a fixed-rate student loan, now’s the perfect time to refinance your student loans to a fixed interest rate loan. Lock in a low rate before the market bounces back and your variable interest rate increases.
Ultimately, whether or not you should choose a variable rate student loan depends on your individual circumstances.
Before you borrow a variable rate student loan, ask yourself the following questions. Your answers will paint a picture of your personal financial situation in relation to private student loan borrowing.
- Is your job/income stable?
- Do you have a plan for repaying your student loans?
- Can you afford the loan you’re borrowing based on expected earnings for your major?
- Can your budget or expected budget afford an unexpected monthly payment increase?
- Have you compared fixed and variable rate loan products from multiple lenders?
- Did you use a student loan repayment calculator to compare those rates?
- Did you ask your lender how often they change variable interest rates and what the rate cap is?
- Have you maxed out your available federal, state, and college financial aid?
- Aside from the low variable interest rate, what other borrower benefits (flexible repayment, autopay discount, academic deferments) does the lender offer?
Here are some other articles to read as you make decisions about paying for college:
- What are the 2021 Federal Student Loan Interest Rates?
- Which is Better: Subsidized or Unsubsidized Student Loans?
- Student Loans & Capitalized Interest: What You Should Know
- 8 Things a Parent Should Ask Themselves Before Taking Out Parent PLUS Loans
- What is a Private Student Loan? Everything You Need to Know
- Saving for College: Short & Long-Term College Saving Tips
- Student Loan Lenders with Cosigner Release
