WorldExecutivesDigest.com | Fixed vs. Variable Interest Rates For Student Loans | Student loans are big business in the U.S these days.
Due to the seemingly continuous rise in the cost of secondary education, U.S students have been forced to become experts on loans before they can even buy a beer. Today, I want to go over fixed vs. variable interest rate student loans for all you art majors out there who are struggling with the process of going thousands of dollars into debt to achieve your dreams.
First, I am going to give a brief, easy to understand definition of fixed and variable interest rate student loans, then unlike many articles on this topic, I’d like to give some advice to consider throughout the loan process—in particular about how to choose your loan type and reduce your interest rates.
FIxed Interest Rates
Let’s begin with the most common type of student loan, a fixed-rate loan. Having a fixed-rate loan simply means your interest rate will remain the same for the entire duration of your loan. There are multiple types of fixed-rate loans for student borrowers, however.
The most common being federal student loans, which come in the following forms and interest rates:
- 5.05% interest rate for both direct subsidized loans and direct unsubsidized loans for undergraduates.
- 6.6% for direct unsubsidized loans for graduate or professional students.
- 7.6% for Direct PLUS Loans for parents and graduate or professional students.
There are also private fixed-rate student loans offered at a number of banks and smaller lenders. The interest rates on these loans vary widely, unlike federal loans, from anywhere around 4.5% to 14%+, depending on the company, and a number of other factors including credit score, income, cosigner income, etc.
Pros:
- Stable monthly payments, less risky
- Offered by Federal Government
Cons:
- Rates typically higher than variable rate loans
- Often take longer to payback
Variable Interest Rates
Variable interest rate loans, once again as the name suggests, are loans where your interest rate can change over time. Variable rates aren’t offered by the federal government. This leaves the market open for private lenders both large and small.
Variable interest rate loans fluctuate based on LIBOR, the London Interbank Offered Rate. For example, a loan provider will charge LIBOR 1.9%(as of today) + their margin (2%-5%+) to equal your total loan interest amount.
Variable interest rates can change either monthly, quarterly or annually depending on your lender’s policies. This makes them higher risk, higher reward propositions for student borrowers.
Pros:
- Usually lower rates than fixed loans
- If LIBOR decreases, so does your interest
Cons:
- Higher Risk
- Federal Government doesn’t offer this loan type
Why LIBOR Matters
The London Interbank Offered Rate is the interest-rate average of interbank lending calculated from estimates submitted by the leading banks in London. The rate is used to determine variable interest rates on student loans as we’ve discussed. Because of this, it’s important to understand LIBOR trends if you plan on getting a variable interest rate loan.
The good news is LIBOR has been on a downward trend since the 80’s. This is partly because LIBOR mirrors the U.S Federal Reserves’ effective federal fund rate and since the 80’s that rate has been held artificially low.
Many economists believe this is the ‘new normal’ and I tend to agree with them. You see, normally interest rates rise when the economy is strong, however in the past decade interest rates have been held at artificially low levels to encourage recovery from the great recession.
The ploy worked, but unfortunately, the Feds haven’t been able to bring rates back up to normal levels for a healthy economy, because every time they initiate a rate hike, the stock and bond markets panic and take a tumble.
This means, inevitably, when a recession hits the Federal Reserve will be forced to cut the fed funds rates even further to increase liquidity and spur investment. Barring major bank instability, which isn’t expected due to increased regulations from the Dodd Frank Wall Street Reform and Consumer Protection act of 2010, LIBOR should follow suit.
That makes variable interest rates more attractive for student loan borrowers. For example, in May of 2000 LIBOR was 7.42%, today it’s under 2%. And over the past decade, LIBOR has only gone over 3% once.
For International Students
International students have a tough time with student loans. Not only is it more difficult to find scholarships for international students, requiring them to request higher total loan amounts, but international students also don’t have the support system that many American students have.
This means increased living costs and stress for students. On top of that, the majority of international students aren’t eligible for federal loans, forcing them to test the private market. Private student loans can range from five to 15 to even 20 years in length vs. a ten-year max for federal loans.
This changes the formula for deciding between fixed and variable interest rates, because with more time for LIBOR to possibly increase you are taking on more risk with variable loans as an international student.
If you’re in this boat, I recommend using a student loan calculator, such as this one from FinAid.org, to determine what potential changes in your interest rate will do to your total loan cost.
In my opinion, international students should either limit their loan period to ten years and choose a variable rate, or go for the longer loan, but at a fixed rate. It’s impossible to predict where LIBOR may sit twenty years from now, making the variable interest rate loan simply not worth the risk for that extended loan period in my view.
How To Reduce Your Interest Rates
Once you’ve decided on your loan, there are a number of ways to reduce your interest rates.
Getting a cosigner, improving your credit (even if you have to hire credit repair services) and refinancing are the best ways to get this done.
For private lenders getting a cosigner or improving your credit score before you get a loan, can help reduce your interest rate. This is because the lender has more confidence in your ability to repay the total loan amount.
Refinancing is another great option to reduce loan payments, even after you’ve already taken out a loan. This is a great tool for borrowers who have improved their financial standing since taking out their loans. You can also use refinancing as a way to switch between fixed and variable rate loans, even if you had a federal loan to begin with. So if LIBOR falls, and you have the cash to pay off your student loans fast, it may pay to refinance with a shorter-term variable rate loan after graduation.
All in all, student loans are far simpler than they are made out to be. Unfortunately, many students don’t put in the time to learn the differences between fixed and variable interest rates, nor do they shop around and look for the best loan they can get—which of course leads to thousands in extra costs over the years.
Hopefully, this article can help you avoid these pitfalls and have a worry-free student loan process.
