When you borrow a private student loan, you often have the choice between fixed and variable rate student loans. Variable rates often start lower than fixed ones, but they run the risk of rising over time. Before opting for a lower variable rate, consider these risks first.
3 reasons to watch out for variable rate student loans
There were variable interest rates on some federal loans as recently as 2006. But nowadays, only private lenders offer variable rates, which are sometimes referred to as “floating” rates.
Unlike a fixed interest rate, which remains the same during your repayment, a variable interest rate could go up or down – or float – based on market changes.
Review your potential lenders’ policies on rate changes before making a decision, and watch out for these three potential downsides, too:
When shopping around with private lenders for a fixed or variable interest rate student loan, you’ll notice that the variable rate ranges are sometimes significantly lower than the fixed ranges. That’s because with a variable rate you’re taking on some risk that the rate might increase over the life of your loan.
But it’s important to remember that the rate you’ll qualify for is determined by your credit score and other factors.
Also, no two lenders have the same criteria for awarding interest rates. It’s possible, if unlikely, that you could receive a lower fixed rate offer from one lender than the variable rate you receive from another lender.
If you’re on the fence about which rate type to select, ask the lenders you’re considering to quote you both fixed and variable rates. Compare these numbers, not the advertised ranges you might or might not qualify for.
A variable interest rate student loan might be especially beneficial if you have a shorter repayment term. If you pay off your loan over five years instead of 10, there’s less time for your rates to dramatically change.
Many lenders will award lower variable rates for shorter terms. At CommonBond, you could score a variable rate ranging from 3.80% to 9.36%, the lowest rate reflecting a five-year repayment term.
Before signing on for a variable rate, be aware of the repayment plans available to you. You might find that your credit history (or your cosigner’s) qualifies you for the lowest possible variable rate. But if you’re looking for more time to repay your loan, make sure that the lender meets those needs, too.
When your variable rate changes, your payments change. That’s because you’re making payments on both your loan’s principal amount and its accruing interest. That’s how student loan interest works.
To ensure you can afford to repay your variable interest student loan, you might prepare yourself for the worst. To do that, ask lenders about their rate cap. That’s the maximum amount that a lender can increase the rate based on market changes.
Depending on the lender, your rate could change monthly, quarterly or annually. For example, some lenders might base their variable rates on changes to the benchmark three-month London Interbank Offered Rate (LIBOR), so your payment amount could change every three months.
In such a case, the bank would add a margin based on your credit evaluation to the three-month LIBOR rate to come up with your variable rate.
Increasing rates could become problematic, particularly if your lender considers the LIBOR monthly. It’s possible that your rate could increase every month for a handful of months or more. But it’s unlikely that month-to-month increases would break the bank.
You can check out decades’ worth of student loan variable interest rate history – specifically the LIBOR before any margin has been added – on Macrotrends. To prepare for an increased rate, see if you could afford your monthly payments at a higher rate using Student Loan Hero’s student loan payment calculator.
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Not having enough regular income or savings might make even incremental increases difficult to cover. That’s why many borrowers opt for fixed-rate loans. A monthly payment that never changes is easier to plan for.
Make a wise choice when reviewing student loan interest rates
If you’re considering a variable interest rate student loan from top recommended private lenders, it won’t hurt to do some homework. There’s more than meets the eye when it comes to variable rates. So before you claim the reward of a lower rate now, learn about how your rate could rise later.
If you forecast having no problem repaying your loan if it rises right along with LIBOR, a variable rate might be perfect for you. But if you’re not sure, you might take some time to reconsider the safer bet of a fixed rate.
Review more tips here to figure out if variable rate student loans are right for you.
Rebecca Safier contributed to this report.