Fixed or Variable Rate? How to Choose When Refinancing Student Loans
Lyle Daly, The Motley Fool
Updated
The type of student loan refinancing you choose has a big impact on how much interest you’ll pay.
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Everyone wants to save money on their student loans, and one of the best ways to do that is by refinancing. By shopping around with the best student loan refinance lenders, you can end up with a lower interest rate and cut down considerably on how much you pay.
When you refinance student loans, you’ll have an important decision to make -- should you refinance with a fixed-rate or a variable-rate loan? The type of loan you choose can have long-lasting repercussions, so we’re going to cover how you can decide.
How fixed and variable rates work
Let’s start by covering what fixed-rate and variable-rate student loans are. In both cases, the names give you a good idea of how the interest rates on these loans work.
Fixed-rate student loans -- A fixed-rate student loan always has the same interest rate. If you get a fixed-rate student loan with a 5.5% APR, that’s your rate until you pay off the loan.
The big advantage with this type of student loan is its consistency. You never have to worry about your loan’s interest rate and monthly payment amount increasing at a moment’s notice. This makes it easy to budget and reduces the likelihood that your student loan will ever be too much to afford, assuming that your financial situation stays the same.
Although there aren’t any glaring flaws with fixed-rate student loans, their interest rates do tend to be higher in the beginning than what you’d get with variable-rate student loans.
Variable-rate student loans -- A variable-rate student loan has an interest rate that can fluctuate with the market. For example, your variable-rate student loan could start with a 4.25% APR, and then increase to 6% if the market rate goes up enough.
Private lenders base variable interest rates on an index rate, with one of the most common being the London Interbank Offered Rate (LIBOR). That means if the index rate rises, drops, or holds, your loan’s interest rate will do the same.
Variable-rate student loans can potentially save you the most money, because lenders typically offer lower starting interest rates on this type of loan than on fixed-rate student loans. If the index rate doesn’t rise or if you’re able to pay off your loan in full before it does, then you’ll end up paying less.
The obvious downside with a variable rate is the risk involved. You’ll end up paying more if interest rates rise.
How to choose the right type of loan for refinancing
Choosing between a fixed and variable rate when refinancing your student loans depends on a few factors:
Your tolerance for risk -- A fixed-rate loan is clearly the safer option, whereas a variable-rate loan is more of a gamble.
The time it will take to pay off your loan -- If you can pay off your student loans quickly, then a variable-rate loan will give you the benefit of a lower starting interest rate without the drawback of paying more later.
Interest rate trends -- In recent years, interest rates have been on the way up, so you could see that happen if you get a variable-rate loan.
That gives you a general idea of how to decide which type of student loan will be a better refinancing option for you. Now, we’ll go over more specific scenarios and which type of loan you should choose in each one.
When to refinance with a fixed-rate student loan
If any of the following are true, then it’s likely in your best interest to borrow a fixed-rate student loan.
You’re on a tight budget -- When money’s tight, you don’t want to have any monthly costs unexpectedly jumping up. A variable-rate loan could leave you struggling to pay your bills should the interest rate increase, and even the possibility of that can make you nervous.
A fixed-rate loan would be better for you in this situation, because you’ll have a consistent monthly payment.
You’ll need more than three years to pay off your loan -- The longer that you have a variable-rate loan, the more likely it is that you’ll see the interest rate go up. Although there’s no way to know for sure when or if this will happen, fixed-rate loans tend to be the better long-term option.
Interest rates are rising -- To be honest, there’s no way for most of us to know what’s going to happen with interest rates in the future. You can, however, look at the current trends to check which direction interest rates seem to be going. If they’re on an upswing, then you should lock in a fixed interest rate.
When to refinance with a variable-rate student loan
Here are the most common situations when it pays to go with a variable-rate loan:
You can pay off your loan within three years -- If you’re confident that you’ll be able to pay off your loan in full in three years or fewer, then a variable-rate loan makes sense. You’ll pay less interest to start, and by the time your interest rate starts going up, you’ll either have paid off your loan already or be very close to doing so.
You’re willing to refinance your loan multiple times -- The disadvantage of variable-rate loans is that the interest rate can go up, but you can mitigate your risk by simply refinancing your loan again if that happens. You could get another variable-rate loan that will have a low interest rate to start, or you could switch to a fixed-rate loan.
This method works well because you can refinance your student loans as many times as you want. You will likely need good to excellent credit so that you can keep qualifying for new student loans at the lowest interest rates.
Interest rates are holding steady or dropping -- When interest rates are on the downswing or seem to have leveled off, it’s a good time to get a variable-rate loan. You can score a lower rate, and there’s less of a chance that it will go up in the near future.
Getting the best deal on student loan refinancing
Although there are people who only want the security of a fixed-rate loan or the lower initial interest rate of a variable-rate loan, it’s smart to be flexible, as both options have their perks.
The key is that you pick the type of loan that best fits your current financial situation. And remember, if necessary, you can always refinance your student loans again in the future. Many of the best student loan lenders have eliminated all their fees, so you’ve got nothing to lose by refinancing again when a better deal is available.
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