Variable vs. Fixed Rate Loans

March 23, 2018
By: Mason Gallik

Rates on student loans can be either variable or fixed. When taking out federal loans, rates are almost always fixed. This means that the rate will stay the same over the life of the loan. This leads to monthly payments that are stable unless you fall behind or miss payments. Rates can be variable though, which means the interest rate and thus your monthly payments can change. This can be a good thing if the rate is decreasing or a bad thing if the rate is increasing.

For private loans and refinancing through a private lender, there are often options for both variable and fixed rates. The variable rate is usually less than the fixed rate for the same term length. This is because the lender is in the business of borrowing money too. The lender gives you a slight discount so that if their rates for borrowing start changing, your rates will move in tandem. Fixed rates are riskier for them since if interest rates rise very quickly, the low fixed rate loan they made to you would be worth less. This is why fixed rate loans usually have higher starting interest rates than variable rate loans.

Variable rates for student loans are often based off the London Interbank Borrowing Rate (LIBOR) or other large interest rate benchmark. The LIBOR may sound complicated, but it really is not. Basically, it is what banks charge other banks to borrow money. In this article, we are going to use the current 1 Month LIBOR for a benchmark, which is around 1.8%. You may think this is low, but you have to remember banks are very dependable borrowers and these are very short loans, so they are perceived as less risky. This is the “variable” part of the loan because this benchmark increases and decreases.

The other part of a variable rate loan is the premium the lender charges you over the benchmark rate. Let’s say Stephanie wants to refinance her student loans and gets approved for a variable rate loan with a current interest rate of 5.5%. The lender states that it is tied to the one-month LIBOR (1.8%) plus 3.7% to get us to the current rate of 5.5%. If the 1 Month LIBOR drops to 1% Stephanie’s variable rate will fall to 4.7% (1% + 3.7% = 4.7%), and her monthly payment will decrease. If the 1 Month LIBOR rises to 3% her variable rate will rise to 6.7% (3% + 3.7% = 6.7%), and her monthly payment would increase.

Say Stephanie wants to refinance $50,000 in student loans, and the new loan has a 15-year term. Her first payment at the 5.5% interest rate would be $409. If her interest rate jumps to 6.7% after the first year, her new payment would rise to $439. If the interest rate falls to 4.7% after the first year, her new payment would be $389. While LIBOR interest rates and thus payments usually move gradually, this example shows how payments can increase or decrease with a variable rate loan. Chances are you will most likely smaller changes in your interest rate and payments each month.

So why is this all important? Interest rates have been rising over the past year and this has been increasing the monthly payments on variable rate loans. Borrowers who take out variable rate loans need to be aware that their payments can change for better or worse each month and understand the risks and uncertainty associated with taking out these types of loans. Another article about how quickly interest rates have been increasing will be coming out soon.