If you are considering taking out any private loans to help finance your education, be aware of this potential difference between federal and private student loans: Federal loans always have a fixed rate — an interest rate that doesn’t change over the life of the loan. Private loans may have a fixed rate or may offer the choice of a variable rate — an interest rate that may fluctuate throughout the loan term based on the ups and downs of the interest rate market.
Your choice of a fixed or variable interest rate may affect the overall cost you pay to borrow. Interest, the money you pay a lender for borrowing money, is calculated as a percentage of the loan balance. And while interest may not be the only cost associated with taking out a loan — various fees and other costs may be included — it is an important factor to consider.
Fixed Rate Student Loan Pros and Cons
Because a fixed interest rate does not change throughout the loan term, fixed rate loans offer predictable payments and an overall estimated cost you can calculate before you even apply. This type of loan may be a good choice when interest rates are rising, when you know it will take several years to pay off your loan or when you are simply more comfortable knowing what to expect in terms of your loan cost and payment schedule.
The downside to a fixed rate is that you may miss out on interest savings in a declining interest rate market.
Variable Rate Student Loan Pros and Cons
Variable rate loans often look appealing compared with fixed rate loans, because their advertised interest rates tend to be lower. If you had the choice of a 6.50% fixed rate or a 4.75% variable rate, the lower rate might seem to be a great deal. But risk is involved, as the variable rate has the potential to rise during the term of your loan.
The potential advantage of a variable rate loan is that it may help you save on interest. However, this savings can happen only if the interest rate market holds steady or declines during your loan term. If market interest rates rise, they can potentially increase your loan’s monthly payment as well as the total cost of the loan.
If you are considering a variable rate loan, ask the lender about the interest cap, an upper limit set to protect borrowers from extreme interest spikes. An interest cap may be set at a relatively high level, but it gives you a figure to play out the worst-case scenario of just how high your payments and total loan cost could go in the event of rising interest rates.
Also find out whether the loan’s interest rates would be subject to adjustments on a monthly or quarterly basis, to get an idea of how many times your interest rate might change. Borrowers who benefit from choosing variable rate loans tend to be those who take out shorter-term loans or who plan to pay their loans off quickly.
Fixed vs. Variable: How Do You Choose?
Only you can decide whether a fixed or variable rate loan is right for you. If you like having the stability of knowing that your interest rate and monthly payment will hold steady throughout the life of your loan, a fixed rate loan offers that peace of mind. A fixed rate loan may also make sense if you anticipate that interest rates are likely to rise during the term of the loan, or if your loan term is so long that you might expect a series of unpredictable ups and downs.
On the other hand, if you’re comfortable with some risk and/or you plan to pay your loan off quickly, a variable rate loan may be right for you. Just remember that while a variable rate holds the potential to reduce your interest costs, it might increase them instead.