Variable vs. Fixed Interest Rates: What's the Difference?
After you submit an application and receive approval for a private student loan, you typically will be presented with the option to select a variable or fixed interest rate on your loan. The interest rate is the price you pay the lender in return for borrowing the money, so it’s important to understand what you’re choosing and why.
What is a Variable Interest Rate?
A variable interest rate is different from a fixed interest rate as it can fluctuate – up or down – over the course of your repayment period. A variable rate is composed of two parts: a fixed margin and a variable interest rate index.
Let’s break it down further…
The fixed margin of a variable interest rate is based on the lender’s assessment of your anticipated ability to repay the loan, and it does not change over the life of the loan. In other words, this component of the variable rate is actually not variable.
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.
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.” The index of a variable interest rate is based on an interest rate benchmark. While the lender selects which index to use, they do not control the value of the index. The most common index used for student loans is the London Interbank Offered Rate (LIBOR) index, the rate at which international banks lend each other funds. As this changes, so will the index component of your interest rate. The margin plus the index totals the interest rate you are charged.
What is a Fixed Interest Rate?
A fixed interest rate is exactly what its name implies: fixed – or the same – for the life of the loan. The interest rate you receive when you take out the loan will be the same interest rate you have throughout the entire repayment period.
Example of a Fixed vs. Variable Interest Rate
When you applied for your loan, you were presented with a fixed interest rate option of 7.00% and a variable interest rate option of 5.00% (4.00% margin + 1.00% index).
The table below shows how the interest rate options would be affected in three different scenarios. Notice the fixed interest rate remains the same in all of the scenarios, and the variable interest rate goes up or down based on the changes in the index.
At the time of applying for your loan, a fixed interest rate will typically be higher than the starting variable interest rate. While the variable interest rate is cheaper to start, you should consider your personal tolerance for the risk that it could go up (or down).
Which is Better: Fixed or Variable Interest Rate?
What’s the best option for you? Assessing which interest rate option is better is a personal decision.
A fixed interest rate loan has the same interest rate for the life of the loan; whereas, a variable interest rate loan changes based on changes to the index (LIBOR). With a variable interest rate loan, you benefit if the interest rate index remains the same or decreases. With a fixed interest rate loan, you don’t benefit from decreases in the interest rate index, but you would also never face an increase in rate.
You should carefully consider your options and determine which rate is more appropriate for your situation.