Are Variable-Rate Student Loans Bad or Good?

When it comes to variable-rate student loans, timing is everything. If rates are high, then a variable-rate student loan is a bad idea. If rates are low, you can be strategic and save on interest.

Variable rates aren’t “good or bad.” It’s more beneficial to think about them as a form of loan that only works well for certain financial situations when rates are low. Read on to see if a variable-rate student loan is a risk worth taking.

The basics of variable-rate student loans

Private lenders offer student loans with both fixed and variable interest rates. Whether you’re refinancing your student loans or are a first-time borrower, your rate is determined by your credit history. Some lenders will also consider your school and area of study.

The difference between fixed and variable student loans is exactly as it sounds:

• Fixed-rate loans offer a reliable payment throughout the life of the loan because the interest rate stays the same.
• Variable-rate loans have payments that can change month to month. This is because the interest rate can change during the life of the loan.

You want the lowest interest rate you can get. It’s common to bring in a cosigner with good credit in order to get a lower interest rate. Your cosigner is legally obligated to make payments if you don’t. This decision should not be taken lightly as it can affect their financial health as well as your own.

Shop around for private student loans and compare rates. Make a note of both the fixed interest rates and the variable interest rates. You may notice that the variable interest rate is significantly lower than the fixed interest rate. This could be something worth taking advantage of. The differences can be drastic, and that’s typically a reflection of LIBOR.

What is LIBOR and why should you care?

The ups and downs of variable student loan interest rates occur in tandem with LIBOR. Be ready to get a little bit technical so you can grasp where the interest rates are coming from.

LIBOR stands for London Interbank Offered Rate. LIBOR is a benchmark interest rate banks use to determine borrowing costs to each other for short-term loans. It’s calculated daily for all major global banks and posted on the Intercontinental Exchange (ICE).

ICE removes the highest and lowest reported borrowing costs and calculates the average rate from the remaining numbers. This is then published in the morning. The current LIBOR rate is important because that average number isn’t just used for banks borrowing from each other. The number is used as a basis for consumer loans, including private student loans.

If some of the banks begin reporting a higher borrowing cost, the LIBOR used with student loans will go up. If you have variable-rate student loans, your interest rates will also rise. How often depends on the lender.

How often do variable-rate student loans change?

If LIBOR rates are calculated daily, does that mean that variable-rate student loan interest will change daily? Not necessarily.

One of the short-term loan borrowing costs reported by banks is the three-month U.S. dollar rate. This is referred to as the current LIBOR rate and is the most commonly quoted according to Investopedia. Banks also report borrowing costs for different loan maturity terms, including overnight, one, two, six and 12 months.

It’s common for lenders to change your interest rate on a variable-rate loan every three months (quarterly). That said, it really depends on the lender because some will change it as often as every month and others as little as every year. This is something you need to pay attention to in the fine print.

How can you calculate what a variable-rate student loan will cost?

The fact is, it’s not possible to pinpoint exactly how much your variable interest rate loan will cost. It’s a risk of taking one out. You should take the following steps to understand the math of a variable-rate student loan:

• Calculate the cost if the variable interest rate remains the same, even though you know it won’t.
• Then, double and triple this payment. See if you can still afford it each month.

You need to be prepared for the worst-case scenario, which is a major spike in your monthly payment amount.

Lastly, when looking at variable-rate student loans it’s important you also ask about interest rate caps. Some lenders, like Earnest, have a cap on how much they will charge in interest. Earnest caps at 8.95% for loan terms that are 10 years or less. If the lender does have a cap, then calculate how much your payment would be if you hit that cap.

Your checklist to see if a variable-rate loan is bad or good for you

Taking out a variable-rate student loan is a risk. It’s one that can be worth it for certain borrowers. If you can check all the boxes on the list below, then a variable-rate student loan might be  a good choice for you:

• If you can take out a loan for a shorter period of time (10 years or less)
• You want your payments to start out smaller but are comfortable with increases
• If your payment doubles or triples, you can still cover it
• The interest rates are low

If any of these aren’t true for you, then it’s not worth the risk. Instead, look into a fixed-rate student loan.

One last tip for the variable-rate student loan

If you didn’t know already, you can refinance your student loans more than once. If you notice rates are high right now, then refinance to a fixed-rate student loan. Then strategize your student loan debt payoff using the variable-rate student loan.

When the rates decrease, you can refinance to a variable-rate student loan, and then:

• You’ve got a smaller balance to pay off; or
• You can take increase payments and take a shorter loan term

Choosing the shortest loan term possible helps minimize risk with variable-rate student loans. The choice is yours, but know it’s not that variable rates are evil. You just don’t want to get caught with one of those student loans if LIBOR rates rise drastically.