What Makes a Variable Rate “Variable”?

What is a variable interest rate?

When searching for a student loan, you will likely discover two different types of interest rates: variable and fixed. The interest rates you find will be dependent on the types of student loans you pursue. The government does not offer a variable rate loan, so all federal student loans will only contain fixed rate options. On the other hand, many private lenders offer both variable and fixed rates on private student loans.

So what makes a variable rate “variable”?

To understand a variable rate, we need to break down the structure of a variable rate and look at the individual components. A variable rate is composed of two parts: a fixed margin and a variable interest rate index.

Part I – Fixed Margin

The fixed margin is a set rate determined during loan origination. Once set, it does not change over the life of the loan. When applying for a private student loan, the lender assesses the creditworthiness of the applicant – and their cosigner if present. Based on this assessment, a fixed margin is applied. Lenders utilize varying criteria to assess the creditworthiness of an applicant, but a general rule of thumb is that a higher credit score leads to a lower fixed margin.

Part II – Variable Interest Rate Index

The second part of a variable rate is based on an interest rate index. This is the component of a variable rate that makes it “variable.” As the index goes up or down, so does the interest rate. Multiple interest rate indexes exist, and the type of index utilized to determine the variable rate often varies based on the type of loan (i.e. mortgages, credit cards, cars, etc.). For student loans, lenders typically refer to the London Interbank Offered Rate (LIBOR) index.

Here’s an example – let’s say you were approved for a loan from Lender XYZ, who offers a variable rate loan. Because of your great credit, you receive a 2.00% fixed margin. At the time of approval, the LIBOR index is 0.20%. Combining the two components, your resulting variable interest rate equals 2.20%. One year later, the LIBOR index increases to 1.00%. At this point, your variable rate would increase to 3.00% (2.00% + 1.00%). At the same time, the interest rate index could decrease. If the LIBOR index decreases to 0.10%, your resulting interest rate would be 2.10% (2.00% + 0.10%). Notice that your fixed margin did not change; it remains at 2.00% for the life of your loan.

Below is a chart outlining the changes in the 1-month LIBOR index over the past 12 years. Since 2009, LIBOR has remained low.

One_Month_LIBOR_Trend

Source: FRED, Federal Reserve Bank of St. Louis, October 26, 2015

Is a variable rate better than a fixed rate?

The key difference lies in the name – a fixed rate loan has the same “fixed” interest rate for the life of the loan, whereas a variable rate changes based on changes to the index (i.e. 1-month LIBOR), as noted above. With a variable rate loan, you benefit if the interest rate index remains the same or decreases. With a fixed rate loan, you don’t benefit from decreases in the interest rate index, but you would also never face an increase in rate. At the time of origination, variable rate loans often start with a lower interest rate than fixed rate loans.

Assessing which rate option is better is a personal decision. You should carefully consider your options and determine which rate is more appropriate for your situation.

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