Are Variable Rate Student Loans the Best Option for You?

variable rate student loans

Variable rate student loans are a common product offered by private lenders to borrowers looking to refinance or consolidate their student debt.

While variable rates are common for private student loans (and mortgages), they are less typical for other types of loans. That’s why some borrowers might be more comfortable with a fixed rate instead.

However, they could be missing out on the potential benefits of variable rate student loans.

Whether a variable or fixed rate student loan makes sense when it comes to student loan refinancing will depend on your financial situation. But if you do it right, you could save hundreds or even thousands in interest payments.

What are variable rate student loans?

Variable rate student loans are defined mainly by how their interest rates are set. Remember, only private student loans have variable rates. All federal student loans have a fixed rate.

A variable rate on any form of credit means that the interest rate you are charged on the debt’s balance can (and often will) change over time. That means a variable rate student loan is an installment loan for which the interest rate, and consequently the monthly payment, can fluctuate.

How a variable rate is determined

However, your lender can’t just raise rates whenever it feels like to get more money out of you. Instead, rate increases are driven by prevailing interest rates in the financial market.

Most private lenders will set and raise variable rates in step with the London Interbank Offered Rate (LIBOR). This is the average of the interest rates banks charge each other to borrow and lend money between institutions. They usually charge a market rate plus the LIBOR rate.

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Historically, LIBOR rates have remained fairly low since plummeting during the Great Recession in 2008. However, since the Fed raised its rates for the first time in Dec. 2015, the LIBOR has risen.

For instance, the one-month LIBOR was at .197% in mid-Nov. 2015, and has since more than doubled .542% a year later.

Still, a .345 percentage point increase won’t add too much to a borrower’s interest rate. In fact, monthly interest (and payments) would only increase $.28 for each $1,000 of the loan’s balance.

Why variable rates are lower than fixed rates

Variable rate student loans also usually have lower initial rates than fixed rate student loans.

When a borrower chooses a variable rate loan, they are assuming the risk that rates might rise and their debt could become more expensive.

But in return for assuming this risk, borrowers can usually get a rate that’s below what they’d be charged with a fixed rate student loan.

How much lower is a variable rate than a fixed rate for student loans? That can depend on your student loan’s length and other terms. Typically, choosing a variable over a fixed rate student loan would result in an initial interest rate that is 1.25-1.75% lower.

When variable rate student loans are a smart option

Because a variable rate student loan starts with a lower interest rate, there can be potential for savings. Even if there is also an increased risk of rates going up.

If you’re considering taking out private student loans or refinancing student loans, here are some reasons a variable rate student loan could make sense.

You think interest rates will remain low

The variable rate for a loan will be tied to general interest rates. Although these have been historically low, recent trends indicate they might be ticking up.

What’s more, with president-elect Donald Trump set to take over the Oval Office in 2017, many economists are forecasting higher interest rates.

The Chair of the Federal Reserve Janet Yellen, however, said that it’s too early to predict results of the election, reports The New York Times.

“We don’t know what’s going to happen,” Yellen said. “There’s a great deal of uncertainty.”

It’s impossible to truly predict the future of interest rates. But if you look at trends you might decide that the lower interest rate now is worth the risk of it rising later.

After all, variable rates would have to rise at least 1.25% before they would even match fixed rates. And even if the variable rate adjusts higher than your initial fixed rate offer, you could still save more over the life of the loan with a variable rate.

You’re looking for lower initial payments

Another benefit of a variable rate student loan is that with a lower initial rate, you also have lower monthly payments.

With the typical savings of a 1.25% on a variable rate student loan, monthly payments will be about $10-12 less a month for each $10,000[c] of the loan.

There are plenty of recent college graduates who have entry-level pay now. However, they may expect big increases in pay in year to come.

On average, workers see big wage growth in their 20s. Most 30-year-olds are earning 60 percent more than their entry-level pay, according to a PayScale survey.

If this sounds like you, a variable rate student loan can help you get lower monthly payments now. Which is great if you need them ASAP.

Just make sure you’re working hard and earning pay increases. This will help offset the risk of monthly student loan payments becoming unaffordable if your variable rate increases.

You’re choosing a short repayment period

A shorter repayment period can also help you minimize the risk of a variable rate increase on your private student loans.

For example, if you have a 10-year repayment period, that exposes you to the risk of rising rates for a long time. But if you are planning to get a two-, three- or even five-year repayment plan, a variable rate student loan starts making much more sense.

That’s because there’s much less time for rates to increase, which makes it more likely that you will keep the savings you get with the initially lower variable rate. Likewise, you can also prepay your student loans and make extra payments to further limit your risk of rising rates.

Of course, a shorter loan term will mean higher monthly payments. So make sure you can realistically afford these monthly costs. After all a shorter, variable rate student loan has a lot of potential for savings on interest.

You’re going back to school and have private student loans

Unlike federal student loans, repayment on private student loans typically can’t be deferred if you are returning to college.

This means many students who want to finish their undergraduate or graduate degree will have to figure out how to cover monthly payments for private student loans. While juggling a full course load in college.

That’s where refinancing private student loans can be a major cost-cutter for borrowers returning to school. Many borrowers with private student loans could refinance to get a lower interest rate. And, choosing a variable rate student loan can get them the biggest savings.

If they refinance with a variable rate student loan, this can help them get lower monthly payments while they finish school. These cheaper payments can ease up a lot of the pressure on a student’s already-tight budget.

Then later on, if rates do rise, they will hopefully have a degree that will help them earn more to cover those higher costs.

So should you get a variable or fixed rate student loan? It’s important you do the math to see what you’re actually saving on interest. And you’ll also need to decide how comfortable you are (or aren’t) with the risk of a rate increase.

But with all that considered, variable rate student loans could still be a good choice. They can help borrowers achieve their debt goals like saving on interest, lowering monthly payments, or paying off debt faster.

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