Should You Refinance Variable Rate Student Loans to Fixed Rate?
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March 30, 2018
By: Mason Gallik
As mentioned in this previous article, variable rate loans usually start out with a lower interest rate than fixed rate loans. Variable rates can change though and this can lead to payments that keep increasing if interest rates are rising. We are currently in an environment where the Federal Reserve has been raising short-term interest rates. Since variable rate student loans are often based off of a short-term interest rate, the variable part of these loans is increasing. If you are concerned your rates and therefore monthly payments are going up, there is always the option to refinance to a fixed rate loan.
If you have a fixed rate loan and rates increase, you luck out by having a loan with a rate below current rates. If you have a variable rate loan though, your payment will start increasing each month. This can be stopped if you refinance to a fixed rate loan. While the interest rate may be slightly higher, you will no longer be at risk of increasing interest rates.
For example, say Patricia has $80,000 in student loans with a variable nterest rate of 8% and a 15-year term. Her monthly payment is $765. The variable rate increases with the 1-month Libor, which is at about 1.8% right now (1.8% Libor + 6.2% premium = 8%). If the 1-month Libor rises by 0.25% every three months, she will have a 9% rate after one year (2.8% Libor + 6.2% premium = 9%). A more detailed explanation on fixed and variable rate loans can be found here. Her payment would gradually rise over one year to $810. If they continue rising in the same manner, after 2 years her interest rate will be 10% and her payment will rise to $854. This is almost a $100 monthly increase from 2 years ago.
Say Patricia compares rates to refinance her variable rate loan and receives an offer of 8.5% fixed for the same 15-year term. While this interest rate is higher than her current rate of 8%, if interest rates increase she will not have a payment that rises to $854. Her payments would be $788 for the life of the loan, which is slightly higher than what her payment is currently. If rates fall, she will be stuck with that higher fixed rate and her payments will not go down like a variable rate loan’s payments would. She can always refinance again at a lower rate, however.
Whether or not to refinance variable rate loans in a rising interest rate environment is ultimately up to you. You may pay less in the long run if interest rates continue to increase. However, fixed rates start out a little higher than variable rates and if rates begin to fall you will not benefit. Fixed rate loans may be worth the peace of mind to know that your payments are going to be the same every month as well. It all depends about your personal risk preferences and budget.