Which type of student loan interest rate could benefit you better?
Lenders typically list two types of interest rates when you’re applying for a student loan or refinancing your debt — variable and fixed. But what do they actually mean for you?
It’s easy to misunderstand how interest rates on student loans work — that variable rate might look low now, but will it actually help you save on interest? We shed light on the basics of these two types of interest rates to empower a more informed decision.
How fixed-rate student loans work
Fixed-rate student loans are relatively straightforward: When you apply for your loan, you qualify for one interest rate that stays the same throughout the life of your loan. You make the same fixed repayments each month and can easily calculate how much you’ll pay in interest over time.
How variable-rate student loans work
Variable-rate student loans are more complicated than fixed rates. As the name implies, variable rates change over the life of your loan.
And so can your repayment amounts, though not necessarily in the way you think they might. The lowest variable rate can sometimes be several percentage points lower than a fixed interest rate.
The easiest way to understand how variable rates actually work is to look at an example. Say you’re looking at a private student loan that advertises variable rates ranging from 2.5% to 11.99%. At first glance, you might think that if you apply for a variable rate, you’ll always get a rate that’s within this range. But that’s not necessarily true.
Lenders calculate variable rates by adding the fixed percentage you’re approved for to an underlying benchmark rate that changes periodically. Third-party institutions come up with these benchmark rates for banks to use in calculating variable rates. When this underlying rate declines or rises, it subsequently affects how much you pay in interest on your variable-rate loan.
Fixed vs. variable rates at a glance
In the simplest terms, fixed rates stay the same and variable rates change. This also means that fixed rates come with monthly repayments that stay the same, whereas how much you owe can change from month to month with a variable rate.
Variable rates tend to have a wider range than fixed rates and can potentially get you a better deal on your interest than even federal student loans — if you have excellent credit.
| Fixed rate | Variable rate | |
|---|---|---|
| How it works | Pay the same rate over the life of your loan. | Pay a rate that changes over the life of your loan. Qualify for a fixed rate that your lender adds to a benchmark rate that can changes monthly or every three months. |
| Monthly repayments | Stays the same. | Changes depending on your current interest rate. |
| Can I predict my loan’s total cost? | Yes | No |
| How does it compare to federal rates? | Usually higher. | Can be lower if you have excellent credit and the benchmark rate stays low. |
Which type of interest rates do different student loans come with?
Your choice of interest rates will depend on your specific loan — federal student loans, private student loans or refinancing your current student debt. Here’s what you might see with the typical loan options.
Federal loans
Federal student loans come with fixed interest rates only, so you don’t have to worry about choosing when you’re filling out the FAFSA. Variable rates on private student loans can sometimes be lower than federal rates, but they don’t always stay low.
Generally, federal loans are the safest, least expensive type of student debt you can take on, because Congress sets the rates each year.
Private student loans
Private student loans typically come with a choice of fixed or variable interest rates, though some loans offer one option only. Fixed rates are generally higher than what you’d get with federal student loans, though variable rates can sometimes offer a better deal — at least in the beginning.
The main difference between private and federal interest rates is that private lenders look at your (or your cosigner’s) personal finances to determine your rate. Typically, you’ll need an excellent credit score and a low debt-to-income ratio to qualify for the lowest private rate, which could still be higher than the federal rate. Federal rates are the same for everyone.
Student loan refinancing
Like private student loans, loans for refinancing student debt tend to come with a choice of fixed or variable interest rates. And like with private student loans, these rates are based on your personal finances, rather than set by an institution.
You generally won’t find a better deal on federal loans by refinancing, but you can sometimes get a lower rate if you swap it for a private variable-rate loan. It can be less risky if you choose a variable rate on a shorter-term loan, so you may not want to take the leap if you have more than five or seven years left on your loan. You also might not want to refinance your federal loans if you’re looking to take advantage of one of the many benefits federal loans offer, which you’ll lose if you refinance.
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How to decide which type of interest rate is better for you
You might want a fixed rate if …
- You’re concerned about your budget. It’s difficult to predict how much you need to put aside for your student loan payments if you don’t know how much they’re going to be from month to month.
- You think rates will increase. Do some reading about the state of the economy. What are experts saying? While they certainly can’t predict the future 100% of the time, you might not want to risk taking out a variable-rate loan if many agree that rates are likely to rise in the near future.
- You need lower monthly repayments. Longer loan terms tend to result in lower monthly repayments — but they increase the risks involved in variable-rate loans because you can’t know whether your variable rate will skyrocket at any point during your loan term. You might want to consider a fixed interest rate if you’re looking to pay it off over seven years or more.
You might want a variable rate if …
- You want lower payments to start. Variable rates tend to start off low and increase over time — and you can always look into refinancing your student loan for a fixed rate if it gets too high.
- Rates are low — and you think they’ll stay that way. Benchmark rates are typically lower in economies recovering from a recession, though they’ve increased slowly over the past few years.
- Your loan is short term. Variable rates have less time to fluctuate over shorter loan terms, meaning there’s typically less risk of paying high rates.
Understanding benchmark and margin rates
Your variable rate is actually a combination of two interest rates: a benchmark rate and a margin rate.
Benchmark rates — also called base rates — are supposed to reflect trends in the lending market, like how much people want to take out in loans versus how much money financial institutions have to pay it off or how much the currency is worth. Financial institutions often borrow from the government’s central bank at a benchmark rate, charging an additional rate so they can turn a profit on your loan.
Margin rates are a fixed rate or a small range of rates that a lender approves you for based on your creditworthiness. If you’re approved for one margin rate, that rate stays the same over the life of your loan. If you’re approved for a range of margin rates, you’ll start by paying the lowest rate and gradually pay more and more after you’ve made a specified number of repayments.
If you decide on a variable-rate loan, you can get a better idea of the rates you’re going to pay by looking at the fine print below the variable rates your lender advertises (at least, it’s usually right below them).
You’ll typically see what looks like code along these lines:
3-month LIBOR + 1.23%–9.45%.
Our example means that the lender offers variable rates combining the three-month LIBOR benchmark rate and a margin rate that can range from 1.23% to 9.45%. If the lender gives you only one margin rate — say 3% — then you’ll pay 3% plus the current three-month LIBOR rate. If you qualify for a range — say 3.44% to 5% — you’ll start off paying 3.44% plus the three-month LIBOR and finish off your loan paying 5% plus the three-month LIBOR.
What are LIBOR and prime rates?
LIBOR and prime rates are the two most common benchmark interest rates that lenders use to determine variable-rate loans. Student loan providers tend to use the LIBOR, though you might come across some lenders who use prime rates.
LIBOR
LIBOR stands for London Interbank Offered Rate. The Intercontinental Exchange Benchmark Administration (IBA) produces benchmarks in five currencies: the US dollar, euro, British pound, Swiss franc and Japanese yen. The LIBOR rate is based on the average short-term interest rate that financial institutions qualify for through London’s interbank market — a financial system where international financial institutions trade among themselves.
LIBOR rates come in several types, but as a student loan borrower, you need to know about two of them only: the one-month LIBOR, which changes monthly, and the three-month LIBOR, which changes every three months.
Prime
The prime rate is more local than the LIBOR rate — it’s based on the federal funds rate of the Federal Reserve, the benchmark of all US-based benchmarks. Typically, prime rates are the federal funds rate plus a few percentage points. The most common prime rate is published in The Wall Street Journal — known as the WSJ Prime rate — though you can sometimes find state or local prime rates as well.
How does this work? The Wall Street Journal polls the top 10 US banks to ask about their prime rate. If seven or more banks change their rate, then The Journal publishes a new interest rate. This means that it doesn’t change from month to month. In fact, it can stay the same for several years or change in as little as a few weeks.
Maximum variable rates
What happens if the market goes haywire — are people with variable-rate loans screwed? Not necessarily. Most lenders cap how high variable rates can go, usually a bit higher than the maximum fixed rate.
In the extreme event that the LIBOR or prime rate skyrockets, everyone paying a variable-rate loan will typically end up paying the same interest rate, regardless of the variable rate you qualified for initially. The chances of this happening are minuscule, but it isn’t an impossibility.
Bottom line
Variable rates are generally riskier than fixed rates and certainly aren’t for everyone. But you might pay less in overall interest if you play your cards right: Stick to a shorter term, and pay attention to what the experts say about the interest rate market.
Want to learn more about how student loans work? Read our comprehensive guide to student loans to learn the ins and outs of federal loans, private loans, refinancing and more.
