Whether you’re just applying for a student loan or you’re trying to refinance your student loans as a way to pay them off, you’ll often get the choice between a variable vs a fixed interest rate. You might be asking yourself, “what does that mean?”
In this article, we’ll take a look at what variable and fixed rates are, how the interest rates are determined, and the pros and cons of each type of rate. By the end, you’ll be able to determine the best interest rate option for you!
What is a Variable Interest Rate?
Variable interest rates fluctuate over the course of your repayment term. This means that your monthly payments can change on a monthly basis because of the interest rates’ fluctuation. However, the interest rate tends to start a little lower than fixed interest rates, depending on your lender. Private student loans typically have both variable and fixed interest rate options.
>> MORE: What is the average student loan interest rate
What is a Fixed Interest Rate?
A fixed interest rate is simply a rate that doesn’t change. The interest rate you received when you took out the loan will remain the same throughout the span of your repayment period. Federal student loans are fixed.
>> MORE: Compare variable vs fixed interest rates across different lenders
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How are Interest Rates Determined?
Lenders have a wide range of criteria that they use to determine the variable or fixed rate of your student loans. Each lender is different but this section covers the overall idea of how most determine the rates.
How are Variable Interest Rates Determined?
You might be wondering if a variable interest rate means that a lender will change the interest rate whenever it feels like it. (I know I did.)
The simple answer is no. Variable rates are determined by two things: a fixed margin and a variable index.
A fixed margin is set by your lender based on your ability to pay. They assess this by looking at your creditworthiness as well as the creditworthiness of your cosigner, if you have one. Generally, a higher credit score leads to a lower fixed margin.
The variable index is based on a benchmark in the financial market, specifically the London Interbank Offered Rate (LIBOR). This rate is the average of the interest rates banks charge each other to borrow and lend money. As such, lenders would charge a market rate as well as the LIBOR rate on your student loans on a monthly basis. However, by 2023, LIBOR will be retired and replaced by the Secured Overnight Financing Rate (SOFR). This rate calculates the cost of borrowing cash overnight collateralized by Treasury securities.
For example, let’s say you have a $20,000 student loan with a fixed margin of 4% and an initial variable index of 1.5%, meaning that your overall variable rate is 5.5%. If the LIBOR, or whatever benchmark your lender, uses increases by 1% the following month, your variable interest rate for that month will be 6.5%. However, if that benchmark’s rate decreases by 2% the month after, your variable interest rate for that month will be 4.5%.
>> MORE: Compare student loan variable interest rates
How are Fixed Interest Rates Determined?
Similarly to the fixed margin in a variable interest rate, your creditworthiness (as well as your cosigner’s creditworthiness) could determine the fixed rate. Your lender might also have a standard fixed rate for student loan borrowers.
>> MORE: Compare student loan fixed interest rates
Pros and Cons of Variable Interest Rates
We discussed a few of the pros of variable interest rates, such as rates typically starting lower than fixed rates. Another advantage of variable interest rates is that you could save on interest if the rate doesn’t rise too much. Luckily, the LIBOR rates haven’t been on the increase in the last few years.
However, variable interest rates are a gamble since they’re subject to change throughout the repayment period. Since the amount fluctuates, you could find yourself having a bad month in which the variable rate increases heavily. This change can make it difficult to pay. Secondly, variable rates are nearly unpredictable, meaning that your monthly payments will change from month to month. Your monthly payments and total costs will be pretty unpredictable throughout the span of your repayment terms.
Pros and Cons of Fixed Interest Rates
Fixed rates are extremely predictable, since the rates are going to stay the same throughout your repayment terms. This quality allows you to plan accordingly for the future with the interest rates in mind.
However, variable interest rates could be lower than fixed rates during your loan’s repayment period. Accordingly, you might spend more money than if you had a variable interest rate. At the same time, fixed interest rates typically start higher than variable rates.
Which is Better?
There’s really no answer for that, since it is ultimately up to you to determine the best option fit for you. Many borrowers might prefer fixed loans because it’s a safer bet and because it will help them budget and plan for the future while they pay for their student loans. However, you might determine that you are in a good position to take on a variable interest rate with the possibility of saving more if the interest rate index is low or remains the same from month to month during your repayment period.
Different factors might weigh into your decision, such as your career path and your financial situation while in college, so it’s important to think about how that will affect you.
>> MORE: Compare student loan interest rates
Final Thoughts
Determining the best interest rate for your student loan is simply up to you and how your finances are looking. After weighing the pros and cons of variable vs fixed interest rates, it will be easier to relate them back to you in deciding what works for you.
You don’t have to make this decision alone. Sparrow’s application allows you to find the best student loans with the best interest rates for you. The platform makes it easy for you to compare real pre-qualified rates without having to apply with lenders one-by-one. Save time by finding the ideal interest rate for you with Sparrow!
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