Refinancing Student Loans: Variable or Fixed Interest Rate?

    Refinancing Student Loans: Variable or Fixed Interest Rate?

    By Amy Fontinelle

    When you refinance your student loans, you’ll often have a choice between a fixed interest rate and a variable interest rate.

    • Choose the fixed interest rate and you lock in your interest rate for the life of the loan. Your monthly loan payment will always be the same, and you’ll know up front exactly how much the loan will cost you in interest over the years.
    • Choose the variable interest rate and the only things that are certain are your starting interest rate, how often the lender can increase the rate, how the lender determines the amount of the increase, and the maximum rate the lender can charge. Your monthly loan payment can change numerous times throughout your repayment period, and there’s no way to calculate your total borrowing costs ahead of time.

    With so much uncertainty, why would anyone choose the variable interest rate? Because it’s lower at the beginning of the loan term, and it could get even lower if interest rates drop. Consider the rates currently available from three private student loan refinancing companies:

    SoFi: As of this writing fixed rate loans cost 3.5 percent to 7.74 percent APR (annual percentage rate); variable rate loans start at 2.14 percent to 5.94 percent APR with caps of 8.95 percent or 9.95 percent APR, depending on your loan term.1 Your interest rate can change monthly based on changes in the one-month London Interbank Offered Rate (LIBOR).

    Earnest: Fixed-rate loans cost 3.5 percent to 7.05 percent APR and variable-rate loans start at 2.13 percent to 5.41 percent APR with caps of 8.95 percent, 9.95 percent, or 11.95 percent depending on your loan term and state of residence. Variable rates can change monthly2 based on the one-month LIBOR.

    Purefy: Fixed interest rates range from 3.95 percent to 6.75 percent APR; starting variable rates range from 3 percent to 5.2 percent APR and are capped at 18 percent if interest rates increase substantially in the future. Variable rates can change quarterly based on the prime rate.

    Doing the Math on Fixed versus Variable Rate Student Loan Payments

    Suppose you refinance $25,000 in student loans with SoFi and want to repay them over 10 years. If you choose a fixed-rate loan, your interest rate could be as low as 4.62 percent, while if you choose a variable rate loan, your interest rate could be as low as 2.94 percent. The fixed-rate loan gives you a monthly payment of $260.54; the variable-rate loan gives you a starting monthly payment of $240.71 — a savings of about $20 per month, according to calculations made with Bankrate’s student loan calculator.

    Thereafter, your payments could increase as often as monthly. If LIBOR doesn’t change, your monthly payment doesn’t change. If LIBOR increases by 0.25 percent, your interest rate increases by 0.25 percent. The variable rate on 10-year loans is capped at 8.95 percent, so your maximum monthly payment could be $316.01, which is $75.30 higher than the starting monthly payment.

    Which Interest-Rate Option Should You Choose?

    A variable rate loan could be a good choice if you think interest rates will stay flat or decrease. But to even consider choosing the variable rate option, you need to have a plan to afford the potentially higher monthly payments in the future. If you’re a recent graduate starting a first job, you can reasonably expect your income to increase over time, making it possible to handle a higher payment. But your other expenses might increase, too — you might move out of your apartment and buy a house, for example. (Related: Buying Your First Home)

    Earnest says borrowers can think about the higher starting cost of a fixed-rate loan as “interest-rate insurance.”3 You pay a higher rate now in exchange for the certainty that your rate will never increase. If you have a low risk tolerance, a fixed-rate loan may be your best option. And you might come out ahead in the long run, depending on what happens with interest rates.

    Since interest rates are about as low as they can get right now, they’ll almost certainly go up in the coming years. Even the Federal Reserve4 says so: its board members predict that the federal funds rate, the interest rate banks pay each other to borrow money short term, will increase by 1 percent from 2016 to 2017 and by another 1 percent from 2017 to 2018. The federal funds rate influences the rate banks charge borrowers for loans.

    Borrowers may love the safety and consistency that comes with a fixed rate, but if the variable rate is very low compared to the fixed rate options, the likelihood of paying less with the variable rate is very high, said Robert Farrington, a student loan debt expert and founder of TheCollegeInvestor.com, a site about the best ways to pay for college and how to get out of debt after college. Unless the interest rate rises 4 percent to 5 percent in the first three to five years of the loan, the variable rate loan will almost always cost less in interest over the life of the loan compared to the fixed rate.

    “Yes, it is a risk, and yes, interest rates will rise because we are at historic lows, but for many people, a variable rate loan will make sense to take advantage of the savings today,” Farrington said in an interview.

    The shorter your loan term, the less risk you take by choosing a variable rate. It’s easier to guess what will happen to interest rates in the short term than the long term, and you’ll have fewer months of higher payments to make if rates increase. The longer your student loan term, however, the more risk you take by choosing a variable rate.

    You can try to guess what will happen with your variable interest rate by looking at what the benchmark rate has done in the past. How volatile is it? How high and low has it gotten? The St. Louis Federal Reserve website shows the history of LIBOR over the last 30 years5 and the history of the prime rate since 1983.6 You can also look at the Federal Reserve’s predictions7 for where interest rates are headed. 

    The Best of Both Worlds

    Finally, with some lenders, your choice isn’t locked in long term. Earnest lets you switch from a variable rate to a fixed rate or vice versa once every six months with no fees. But there’s still some risk here, since your new APR will depend on market interest rates and your financial profile at the time you request the change.

    The better your financial profile, specifically your credit history and credit score, the more likely you are to win a lower interest rate. Of course, paying off your student loans on time helps build your credit history in the first place.

    Indeed, the major credit bureaus view student loans as installment loans for the most part. There’s an immediate benefit to your credit score and credit history by keeping your student loan payments current. And a good credit score will help for future loans and in negotiating terms for consolidation and refinancing. Since graduating students typically don’t have extensive credit histories, then, student loans can be a useful vehicle for establishing a credit score.

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    1 SoFi, “Student Loan Refinancing Rates & Terms,” accessed May 31, 2016.

    2 Earnest.com, “How Does an Interest Rate Change Affect My Student Loan?” December 16, 2015.

    3 Earnest.com, “How do I decide between a fixed interest rate and a variable one?” accessed May 31, 2016.

    4 Board of Governors of the Federal Reserve System, “Advance release of table 1 of the Summary of Economic Projections to be released with the FOMC minutes,” March 16, 2016.

    5 Federal Reserve Bank of St. Louis, “Graph: 1-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar.”

    6 JPMorgan Chase & Co., “Historical Prime Rate.”

    7 Board of Governors of the Federal Reserve System, “Advance release of table 1 of the Summary of Economic Projections to be released with the FOMC minutes,” March 16, 2016.

    The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.

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