Fixed vs. Variable Interest Rate Student Loans

Student loans either have a fixed interest rate or a variable interest rate. All federal student loans carry a fixed rate for the life of the loan. Private lenders, such as banks, credit unions and other financial institutions, typically offer both fixed and variable interest rate options.

Fixed interest rate student loans offer more certainty on overall borrowing costs. Variable interest rate loans might initially be less expensive as variable rates tend to start out lower, but may become more expensive as the interest rate increases. The better interest rate option depends upon the borrower’s specific circumstances.

Fixed Interest Rates on Federal Student Loans

Fixed interest rates do not change during the life of the loan. A borrower with a fixed interest rate loan can project their total future loan payments with a high degree of confidence.

The interest rates on federal student loans are fixed for the life of the loan. The fixed interest rates on new federal loans change each July 1, based on the last 10-year Treasury Note auction in May, plus fixed margin that depends on the type of the loan. The interest rates are based on the 10-year Treasury because it is of similar maturity to the student loans. The margins and caps are shown in this table.

Unlike private student loans, the interest rates on federal student loans do not depend on the borrower’s credit.

Fixed Interest Rates on Private Student Loans

The interest rates on private student loans are based on different index rates, such as the 1-month and 3-month London Interbank Offered Rate (LIBOR) index or the Prime Lending Rate. Currently, most private student loans are pegged to the LIBOR index because the lender’s cost of funds is also pegged to the LIBOR index. This provides the lender with a predictable spread between the borrower interest rate and the lender’s cost of funds.

In addition to a benchmark index rate, the lender models how the index might change over the repayment term of the loan. An adjustment is calculated to yield equivalent interest income to a variable-rate loan over the same repayment term. Since the fixed interest rate depends, in part, on the repayment term of the loan, private lenders are resistant to changes in the repayment term on a fixed-rate loan.

Interest rates on private student loans are typically clustered into four, five or six tiers based on the credit scores of the borrower and the cosigner. Each tier is assigned a different interest rate.

This table illustrates a hypothetical set of interest rate tiers. Most lenders do not reveal their tiers or interest rate mappings, as they consider it to be a trade secret.

Since lenders do not use a continuous mapping of credit scores to interest rates, a slight change in credit score can sometimes lead to a big change in the interest rate, if the borrower’s credit score was at the edge of a tier.

Variable Interest Rate Student Loans

Variable interest rates change at specified intervals. A borrower with a variable interest rate loan might see their loan payments change as frequently as every month. The most common reset intervals are monthly, quarterly and annually.

Variable interest rates are partly determined by a short-term interest rate benchmarks, such as the 1-month LIBOR or the 3-month LIBOR. The loan agreement specifies which published benchmark rate is used. Lenders add an interest rate margin on top of the benchmark rate to determine the rate charged to the borrower. The interest rate margin is determined by the credit scores of the borrower and cosigner at the time of application and does not change over the life of the loan.

If the borrower’s credit scores have improved significantly since the loan was originated, the borrower might be able to get a better interest rate by refinancing their student loan.

Variable interest rate student loans frequently include caps and floors on the interest rate charged. If the benchmark rate plus the applicable interest rate margin is above the cap, the cap rate applies. If the benchmark rate plus the applicable interest rate margin is below the floor, the floor rate applies.

Is It Better to Have a Fixed or Variable Interest Rate Loan?

Comparing student loans with fixed and variable interest rates may be difficult. The variable-rate loan may start off with a lower interest rate, but that interest rate may increase throughout the repayment term.

Fixed interest rate student loans provide greater clarity on future payments, providing the borrower with stable monthly loan payments.

On the other hand, a borrower with greater financial flexibility may prefer a variable interest rate loan because they are better able to assume the risk of higher payments if interest rates rise. Also, in a rising-rate environment, the interest rate on a variable rate loan will be highest when the loan balance is lower.

Interest rate risk is directly related to the life of the loan. A variable interest rate loan may be preferred if the borrower chooses a loan with a shorter repayment term, since the interest rate is unlikely to increase too much.

Generally, lenders price their fixed and variable-rate loans to yield the same total amount of interest revenue over the life of the loan. So, if a borrower is able to pay off the loan early, before the interest rate rises too much, they might be able to save money by choosing a variable-rate loan.

Loans with a low fixed interest rate tend to involve a shorter repayment term when prevailing interest rates are rising. A shorter the repayment term yields a lower fixed interest rate.

Although a lower interest rate may yield a lower monthly payment, a shorter repayment term yields a higher monthly payment. Usually, the shorter repayment term dominates the lower interest rate in determining the monthly payment. Most of the savings from a higher monthly payment comes from the shorter repayment term, not the lower interest rate.

Finally, borrowers should consider the difference between the fixed and variable interest rates they are offered by a lender. If there is little difference between the two interest rates, the borrower might be better off choosing the fixed interest rate. The small amount of expected interest savings at the start of the loan may not be worth the risk of having a variable interest rate that can rise substantially.