Student loan lingo gets a little confusing, especially while trying to decide which student loans are best for you. You’ve likely heard that student loans have either variable or fixed interest rates. It’s important to take the time to understand the difference between the two. This small detail makes a big difference during student loan repayment; it can affect your monthly payment and the overall cost of a loan.
A variable rate student loan has an interest rate that changes, or varies, over time. Variable interest rates in general rise and fall with the prime rate set by the Federal Reserve. In other words, they follow market trends which is defined by the overall health of the economy.
With a variable rate student loan, you can expect your interest rate to increase or decrease over time as you pay back your student debt. If it happens to decrease, you will pay less in interest, but if it happens to increase, you will end up paying more.
A fixed rate student loan has an interest rate that doesn’t change with the market. So after receiving the loan, you don’t have to expect any sort of change to your interest rate, offering more certainty during repayment. Keep in mind that a fixed interest rate offer can still change with the market, but it will remain fixed after an applicant receives his or her loan.
There are different reasons for choosing a variable rate versus a fixed rate.
Variable rate loans are typically offered at lower interest rates compared to fixed rate loans. Having a lower rate is a great thing because it limits the cost of interest during repayment. While this is a good thing, there is some risk involved. Since the rate changes with the market, there is a possibility that you could have a much higher interest rate in several years. This is only possible if the market rate increases. On the flip side, there is also a chance that the rate could decrease with the market in several years. It is a riskier option for borrowers that could pay off or cost more, so there is less certainty with this option.
Contrarily, fixed rate loans are usually offered at higher rates than its variable rate counterpart. Having a higher rate is not good thing because it costs more in interest payments over the life of the loan. Despite this, fixed rate loans offer much more certainty than a variable rate loan because it does not change with the market. This can be preferable to some borrowers. Why? You know what you’re going to be paying in interest each month, and you don’t have to worry about that changing for the worse.
There it is. With a variable rate loan, you have the possibility of a lower rate and saving money, but that could change and end up costing you more money at a higher interest rate. With a fixed rate loan, you will typically have a higher rate at the start, but you will know your loan obligations with more certainty.
Which do you choose? In a market where interest rates are predicted to fall, the obvious choice is a variable rate loan because the rate is more likely to drop in the future. In a market where interest rates are expected to rise, you should lock your interest rate in with a fixed loan to avoid the prospect of a higher rate.