By Zack Friedman
Founder & CEO, Make Lemonade
Zack Friedman is the founder and CEO of Make Lemonade, a personal finance website with free financial tips, tools and reviews to help save you money on your student loans, personal loans, investing, banking, mortgages, credit cards and more.
Zack is a personal finance and student loan expert and shares his thoughts with Purefy on how a fixed interest rate can save you money in a rising interest rate environment when you refinance your student loans.
Fixed interest rate or variable interest rate? It’s one of the most frequently asked student loan refinance questions at Make Lemonade.
The choice between a fixed interest rate or variable interest rate student loan – along with your loan term – is one of the most important student loan decisions. Why? Your decision impacts how interest is calculated on your student loan, and each choice has a different outcome.
What is the difference between a fixed interest rate and variable interest rate?
The answer may seem obvious to many, but let’s take a closer look.
1. Fixed Interest Rates.
A fixed interest rate means that the interest rate on your student loan stays the same over the life of the loan (e.g., the number of years that your student loan is outstanding), which means that your interest rate will never change (until you refinance your student loan or choose an income-driven student loan repayment plan).
If you like certainty, a fixed interest rate is fully predictable. With a fixed interest rate student loan, you will always know the total monthly interest payment you will make over the life of the loan.
2. Variable Interest Rates.
A variable interest rate (or floating rate) means the interest rate on your student loan will change over the life of the loan.
Why? Your interest rate is based on an underlying interest rate benchmark. Many private student loan lenders use the London Interbank Offered Rate (LIBOR), which is the interest rate that banks lend to each other in the wholesale money market in London. LIBOR is also a standard index used in U.S. capital markets. Lenders use LIBOR as a baseline and then add a fixed margin, or profit, plus your personal credit risk to arrive at your interest rate.
For example, a variable student loan interest rate may be set based on 1 Month LIBOR, which means that the variable student loan interest rate charged on a student loan may change each month based on a movement in LIBOR. This means that your student loan interest rate may change monthly (as 1 Month LIBOR changes), which means you may have a different student loan payment each month.
Therefore, an increased in LIBOR in a given month means that your student loan payment in that month will go up, as will the total interest due over the life of the loan. A decreased rate change in a given month means that the payment in that month will go down, as will the total interest due over the life of the loan.
When I refinance my student loans, should I pick a fixed interest rate or variable interest rate student loan?
When you refinance your student loans, initial variable interest rates are typically lower than fixed rates. Does this mean that you always should choose the variable interest rate student loan? Not necessarily. Let’s take a look.
Fixed Interest Rates.
If you like the predictability of paying the same interest rate each month and don’t want to worry about your monthly payments potentially changing each month when interest rates change, then a fixed interest rate student loan is probably best for you.
Plus, if you plan to pay off your student loan over a longer time period (e.g., 10-20 years), then you may prefer to lock in your interest rate now and not be impacted by changes in interest rates in the broader market.
A primary disadvantage of a fixed interest rate student loan is that if interest rates do not rise, or even decline, your interest rate will not change accordingly. Therefore, you would pay more interest than if you had a variable interest rate student loan.
Variable Interest Rates.
Variable student loan interest rates are typically priced lower than fixed student loan interest rate loans and can offer more savings initially.
If you plan to pay off your student loans over a shorter time period (e.g., 10 years or less), then you may prefer to choose a variable interest rate. All else equal, shorter duration student loans tend to have lower student loan interest rates than longer duration student loans because the payback period is shorter, which means relatively less risk for the lender.
However, if interest rates rise, then you should be prepared to make higher monthly payments and pay higher total interest over the life of your student loan.
When Make Lemonaders ask whether they should choose a fixed or variable interest rate when they refinance their student loans, it is really a personal choice that should be considered along with your personal financial situation, student loan amount and student loan term. However, in a rising interest rate environment, you may end up with a higher interest rate over the long-term if you choose a variable interest rate.
How do interest rate movements affect my student loan interest rate?
If you already have or are considering a fixed interest rate for your student loan, then movements in interest rates have no impact on your student loan interest rate. However, by refinancing your student loans, you may be able to get a lower interest rate.
If you have or are considering a variable interest rate for your student loan, then interest rate movements impact your student loan interest rate.
Therefore, when selecting a fixed or variable interest rate, you should incorporate your view, if any, on interest rate movements (up, down or steady) over the course of your student intended student loan repayment period.
Last December, the Federal Reserve unanimously raised its benchmark interest rate by 0.25%. The Fed also forecast three additional interest rate hikes in 2017. While this is good news for savers in the form of higher yielding savings accounts, higher interest rates adversely affect consumer borrowers with variable interest rate loans such as student loans (as well as credit card and mortgage debt) in the form of higher interest costs.
While the December rate hike was minimal, there are likely to be more rate increases this year.
If you currently have a variable interest rate student loan, you can refinance your existing variable student loans to a fixed interest rate student loan and potentially save money in a rising interest rate environment.