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When taking out or refinancing student loans, you may notice that private loans come in more flavors than government options. With that flexibility comes a choice between fixed and variable interest rate loans.

So, what is the difference? Which should you choose?

Fixed vs. Variable Interest Rate Loans

The short answer is that with a fixed-rate loan, you get what you see. The interest rate on the student loan will not change — it is “fixed” until you pay off the balance.

On the other hand, a variable-rate loan may start out with a lower rate than fixed-rate counterparts but can change as central banks cope with ups and downs in the economy. We’ll outline exactly how this change can happen below, but first, let’s go a little more in-depth.

Modern government student loans are “one size fits all” — there are different types of loans, but everyone who takes out the same type of loan at the same time pays the same interest rate. Once you take a government loan out, the interest rate is fixed for the life of the loan.

Interest rates on private student loans depend on your credit score, the repayment term of the loan (how long you have to pay it back), and whether you choose a variable or fixed interest rate loan.

Most private student lenders offer borrowers a choice between a fixed- or variable-rate loan. Which one is right for you depends on your circumstances — and your tolerance for risk.

If you choose a variable interest rate private student loan, you’ll start out with a better interest rate than you’d get on a fixed-rate private loan with the same repayment term.

As of March 1, 2017, Citizens Bank, one of the most popular lenders on the Credible platform, offered fixed-rate student loan refinancing at rates ranging from 3.74 percent to 7.74 percent (the shorter the loan term and the better your credit, the lower your rate).  You’d start out paying between 2.39 percent and 7.68 percent interest if you chose a variable-rate refinance loan from Citizens.

If you choose a variable-rate loan, your interest rate can move up or down while you’re still paying off your loan, depending on what’s happening to the index rate that your loan is pegged to.

If you choose a fixed-rate student loan, you’ll pass up the chance to start out making lower monthly payments. But if interest rates go up, you’ll be immune — your monthly payments will remain unchanged.

Variable and fixed interest rate indexes

As the chart below demonstrates, the two most commonly used reference rates for variable-rate student loans — the London Interbank Offered Rate (LIBOR) and the prime rate — can swing dramatically in a relatively short period of time.

The reason these indexes rise and fall has to do with the efforts of the Federal Reserve and other central banks to smooth out ups and downs in the economy. When time are tough, central banks take steps to lower interest rates, in order to encourage borrowing that gets the economy growing and creates jobs. When the economy shows signs of overheating, policymakers raise rates to keep the dollar and other currencies from being devalued so much that inflation gets out of hand.

The gray bands in the chart above represent recessions. Interest rates have been well below historic lows since 2008, when policymakers took drastic measures to stimulate growth in the wake of the mortgage meltdown and global recession.

Until recently, those measures hadn’t been as effective as initially hoped. But in December 2015, with the economy seemingly on a path to recovery, the Fed raised its target for a key short-term interest rate for first time since 2006.

Although interest rates have seemingly little leeway to move in any direction but up, it’s hard to predict when, or how fast, they’ll rise. Fed policymakers nudged rates up again in December, 2016 and March, 2017. Additional hikes in the federal funds rate will depend on continued U.S. economic growth, particularly in jobs and wages.

The historical chart above can’t tell you where interest rates will be in the months or years ahead. But it can give you an idea of how far they can swing, and how fast. Pulling the slider bar on the chart lets you look back farther in time.

How interest rates on private student loans are set

Most variable interest rate private student loans are indexed to one of two reference rates — LIBOR or the prime rate.

The prime rate, which is what commercial banks charge borrowers, is primarily driven by the federal funds rate. LIBOR is an overseas equivalent of the federal funds rate — it’s what banks charge each other for short-term loans.

Once they’ve decided which reference rate to use as an index, lenders add a fixed margin on top of it. The riskier the borrower, the higher the margin.

The margin allows lenders to cover expenses including losses on loans that don’t get paid back, and also make a profit. But if lenders set their margins too high, they’ll lose business to more efficient lenders who are able to outcompete them by charging lower rates.

Notice that in the chart above, the prime rate is higher than LIBOR. But that doesn’t mean loans indexed to the prime rate are more costly. Lenders simply add a smaller margin to loans that track the prime rate than lenders who use LIBOR. The “spread” between the prime rate and LIBOR remains fairly constant over time, so if the interest rate on loans indexed to LIBOR is increasing, chances are the rate on loans benchmarked to the prime rate is increasing by about the same amount.

Variable interest rates can adjust monthly, quarterly, or annually. If you already have a variable-rate loan, it’s important to be prepared for this. You can check your loan documents to see what type of loan you have, and if it’s a variable-rate loan, whether it’s indexed to LIBOR or the prime rate.

While rates can move in either direction, lenders typically set a ceiling that limits how high your rate can go.

Real world rate examples of variable- and fixed-rate loans

Below are examples of starting rates and rate ceilings offered by lenders who compete for your business on the Credible platform. Notice how starting rates are higher for loans with longer repayment terms. You can use Credible’s prequalification tool to see the rates you’ll qualify for in about two minutes, without affecting your credit score or sharing your personal information with lenders until you see an option you like.

Starting rates for variable interest rate loans, student loan refinancing

Lender Reference rate How often do rates change?  Term (years) Initial rate (APR)  Ceiling
Citizens Bank  1-month LIBOR 1st of the month
  • 5
  • 10
  • 15
  • 20
  • 2.39 – 7.38%
  • 2.93 – 7.53%
  • 3.18 – 7.63%
  • 3.38 – 7.68%
21%
 CollegeAve 1-month LIBOR 1st of the month
  • 5
  • 7
  • 10
  • 12
  • 15
  • 2.88 – 5.76%
  • 3.63 – 5.76%
  • 3.63 – 5.88%
  • 3.93 – 6.13%
  • 3.93 – 6.13%
25%
Earnest 1-month LIBOR 1st of the month
  • 5-20
  • 2.55 – 6.02%
8.95% – 11.95%
(depending on your term)
 EDvestinU 1-month LIBOR Last business day of the month
  • 15
  • 20
  • 3.53 – 5.93%
  • 3.93 – 6.33%
N/A
 iHELP LIBOR 1st of the month
  • 20
  • 3.5 – 9.5%
N/A
 MEFA 1-month LIBOR 1st of the month
  • 15
  • 3.57- 6.47%
20%

Rates valid as of March 1, 2017.

Starting rates for variable rate “in-school” loans

Lender  Reference rate How often do rates change?  Term (years) Initial rate (APR)  Ceiling
Citizens Bank 1-month LIBOR 25th day of the month (or next business day of proceeding month)
  • 5
  • 10
  • 15
  • 2.78% – 9.78%
  • 3.13% – 10.03%
  • 3.28% – 10.03%
 21%
CollegeAve 1-month LIBOR 25th day of the month (or next business day of proceeding month)
  • 8
  • 10
  • 12
  • 15
  • 3.06% -10.06%
  • 3.06% – 10.06%
  • 4.53% -10.27%
  • 4.53% – 10.27%
25%
 iHelp 3-month LIBOR Quarterly
  • 20
  • 3.50% -9.50%
 No maximum rate

Rates valid as of March 1, 2017.

Strategies for choosing between variable and fixed interest rates

If you’re considering taking out a private student loan to continue your education or refinance student loan debt, how do you decide whether a variable-rate or fixed-rate loan is best for you?

Deciding between a fixed and variable rate has a lot to do with your attitude towards risk. If you think you can handle the uncertainty, a variable-rate loan might be a good option for you. Variable interest rates can be good option for those who need a loan for a short period of time, or who are able to make more than the minimum monthly payments.

For loans offered by private lenders, interest rates will depend on a number of factors, including the repayment term of the loan and the borrower’s creditworthiness. All other things being equal, the shorter the loan term, the lower the rate.

For borrowers who are refinancing student loan debt, moving into a loan with a shorter repayment term can produce the most dramatic interest rate reductions, and maximize savings over the life of the loan. Choosing a variable rate loan can magnify the savings, as long as the interest rate doesn’t increase dramatically.

The good news for those with variable rate loans is that if your rate does start to rise, you can refinance into a fixed-rate loan. If you need to borrow a lot of money for a longer period of time and aren’t comfortable with the uncertainty of not knowing what your interest rate will be in the years to come, you might be better off with a fixed-rate loan.

Credible can help you determine whether you qualify for a lower interest rate by letting you compare multiple offers from multiple, vetted lenders — think Expedia for student loan refinancing. This will not affect your credit score, and Credible will not share your personal information until you’re ready to start talking to lenders.

Borrowers who used the Credible platform to refinance student loan debt into a loan with a shorter repayment term can expect to save about $19,000 over the life of their loans.

Another option: hybrid loans

CommonBond’s hybrid loan is an exception in the world of student loans, because it offers you both a fixed and variable rate for the same loan. The CommonBond hybrid loan is a 10-year term loan that starts out as a fixed-rate loan, and then becomes a variable-rate loan after five years.

According to CommonBond, it takes the average borrower about six years to pay off a 10-year term loan, if they are able to make prepayments (payments that are larger than the minimum monthly loan balance). So if you think you’d be able to make prepayments on your loan, the hybrid loan might be a good option for you.

This hybrid loan gives you the benefit of having a fixed interest rate to start off with — so if you’re able to pay off your loan within the first five years, you’ll never have to deal with the uncertainty of a variable interest rate.

The drawback of this strategy is that if you’re not able to make prepayments on your loan, you could end up paying a higher rate during the last five years of payments.

Pros and cons of fixed vs. variable interest rate loans

Fixed interest rate Variable interest rate
Interest rate
  • The rate you start with is the rate you’ll have throughout the term of the loan.
  • The rate on your loan may increase or decrease along with the reference rate (such as LIBOR or the Prime Rate) that it’s indexed to.
Monthly payment
  • Your monthly payment will remain constant through the term of your loan (unless you choose an income-driven repayment plan).
  • Your monthly payment can fluctuate depending on changes in the interest rate.
Pros
  • Certainty of the same rate and monthly payment throughout the term of the loan.
  • Generally offers a lower rate at the outset.
  • If the the reference rate does not rise, can provide a lower overall repayment amount compared to a fixed rate loan.
Cons
  • Interest rate will be higher than variable-rate loan with the same repayment term.
  • Less predictability in terms of your monthly payment amount.
  • Possibility of your interest rate increasing in the long term (variable rates are often capped, but that cap is often high, at 15%-18%).

 

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