If you’re looking into refinancing your student loans, one of the big decisions to make is choosing between variable and fixed rate loans. There are several factors to keep in mind when making that choice that aren’t immediately obvious, so let’s break them down one at a time.
A variable rate loan is exactly what you might expect: a loan where the interest rate can move up or down over time. But what exactly causes them to be variable? Variable rates are generally pegged to LIBOR, (the London Interbank Offered Rate) which is the average interest rate one major bank will charge another major bank when borrowing.
As it happens, LIBOR has been at near-historic lows for the last few years since the financial crisis in 2009 translating into correspondingly low variable rates you’ll see when refinancing your student loan. If you look at the offerings of major student lenders, variable interest rate loans are often set a couple of percentage points lower than fixed rate loans because borrowers are taking on an interest rate risk in the event that LIBOR rates rise. This means that if you choose a longer repayment term, there’s no guarantee that whatever excellent rate you get today will stay the same in 15 years or even 5 years. It’s difficult to imagine that rates will drop much lower than they are now, meaning that interest rates will most likely rise in the future. The longer a repayment term you select, the larger the risk that your variable rate will rise during the term of your loan. Some variable rate loans have caps on how high the interest rate can reach, and it’s definitely worth taking that into account when making your decision.
Compare that to a fixed rate loan. In a scenario where you choose a fixed rate loan, you accept a slightly higher interest rate now, but are guaranteed that no matter how much those variable interest rates might fluctuate, your rate will not change for the life of your loan. It’s a more conservative option than a variable rate and can be a solid choice in certain situations.
What Does It All Mean?
The next step is taking all of this into account and figuring out how it should affect your own student loan refinancing. Since variable rates are so low now and are likely to rise in the future, a variable loan is probably a good choice if you are planning on repaying your loan quickly and if you are in a good position to take on some interest rate risk. Let’s take a look at the case of a newly minted anesthesiologist (with an average starting salary of around $250,000). She opts to devote the first few years post-residency to paying off her medical school student loans as quickly as possible. After exploring her options, the best fixed rate she is offered for a 5 year term is 4.0% compared to a 2.5% variable starting rate she could also choose.
By Aryea Aranoff