You’re going to make a lot of decisions when it comes to your student loans. From choosing repayment plans to selecting the lenders you’d like to work with, you should get as much information as possible about your loans before you sign on the dotted line.
However, one of the most important items you’ll have to check off your list before you even get started is deciding whether your loan should have a fixed or variable interest rate. While each has its own advantages, there’s an option that is better suited for you and your individual circumstances.
So, before you get too far into the student loan application process, take a moment to explore the pros and cons of fixed and variable interest rates so you can make the right decision. After all, the interest rate on your student loans could affect your finances for many years after you graduate.
If you’re not already familiar with the concept of interest rates, here’s a simple way of understanding what they entail.
When you get a loan, or any other form of credit or financing, the amount of money that you borrow is called the principal. But before you can gain access to these funds, your lender will tack on a percentage of the principal each year (or in some cases, each month) for you to use their money. This is the loan’s interest rate.
Here’s an example of an interest rate in action. Say you wanted to borrow $10,000 from your local bank to pay for college. Your bank offers you the money at five percent interest each year, as long as you keep making your monthly payments. This means you’ll be paying $500 a year in interest on your student loan spread out over 12 months. By dividing this amount into 12 monthly payments, you’ll see that roughly $42 dollars a month goes towards interest, with the remaining amount going towards your loan’s principal.
Now that you know how interest works, here’s some more information on how they can affect your student loans.
When you get a fixed interest rate on a student loan, the amount you’ll be paying in interest will remain the same throughout the term of the loan – or basically until the loan is paid off. This often makes student loans with fixed interest rates a great choice for borrowers who prefer paying the same amount each month towards their loans, and makes setting up automatic payments much easier.
Unless your loan is part of an income-driven repayment plan, where your payments are based on 10 percent of your income, your monthly payments will stay the same forever. However, the downside with fixed interest rates on student loans is that they usually come in a bit higher than variable interest rates – usually by one percent or more.
One of the biggest advantages in favor of fixed rate student loans is that many financial aid advisors recommend having federal student loans over private student loans. This is not only due to the protections and benefits associated with federal loans, but it’s also because federal loans usually offer fixed interest rates that give borrowers a clearer picture of their upcoming expenses prior to graduation.
A variable interest rate on student loans is an interest rate that can increase or decrease periodically based on the reference rate your loan is indexed to. Your lender will often base all their loans on the same reference rate, and this rate could be affected by such things as inflation, the health of the economy and the amount of money currently disbursed to other borrowers.
When you’re ready to obtain a loan, lenders who offer variable interest rates will usually be able to offer you a loan with an interest rate that is noticeably lower than loans with fixed interest. However, because this interest rate is variable, your monthly payment could change annually – meaning your payments could be lower or higher depending on fluctuations in your lender’s reference rate.
If the reference rate stays at the lower interest rate, your student loan repayment amount will be lower than what you’d pay on a fixed loan. But if the reference rate rises, you could end up paying more each month than you would if you had a fixed interest rate loan.
The unpredictability of the variable interest rate over the long term usually makes the decision for many borrowers. Yet, if the worldwide economy remains fairly stable and economic inflation isn’t excessive, your interest rate could still be lower than some fixed rate loans, even if you see slight increases in your interest rate over its lifetime.
Whether you choose a student loan with a fixed rate or variable rate, there may come a time when you decide to refinance or consolidate your loans anyway. This can save you thousands of dollars by helping you earn a lower interest rate, or reduce your payments each month by extending your repayment period for a longer term.
If you’re still unsure about what to do with your student loans or want more information on either of these choices, fill out our online form or speak with one of our student loan experts by phone at (800) 670-4196. We can walk you through the advantages and disadvantages of these types of loans, and help you on your way to financial freedom.