One of the first lessons in financial planning 101 is to embrace the mantra: “it depends.” Answers are rarely black and white when it comes to finances, which is one reason people stumble when debating whether or not to use a variable or fixed interest rate on student loan refinancing. Instead of offering a definitive answer (because there isn’t one), let’s look at some of the pros and cons of using each type.
Why Refinance Student Loans
Refinancing student loans can help you:
1. Consolidate all student loans into one place for an easier payment.
2. Get a lower interest rate.
Refinancing federal loans to a private loan means giving up protections and programs such as forbearance, deferment and forgiveness. However, if you can shave 2 percent or more off your interest rate, it very well may be worth giving up the protections of the federal government.
Keep in mind, those looking to refinance student loans need excellent credit and all loans in good standing to receiving the crème de la crème in interest rates.
Fixed Interest Rate
Personal finance experts advise young college graduates to refinance student loans to a fixed interest rate. Why? Because it offers one steady rate over the life of the loan. Borrowers don’t have to worry about a jump in interest or aggressively paying down the debt before the rate increases.
Similar to choosing a 30-year fixed mortgage over an adjustable-rate mortgage, refinancing with a fixed interest rate gives the borrower stability. The fixed interest rate might be ideal for anyone struggling with large amounts of student loans that might take several years or a decade to pay off. Fixed interest rates are as low as 3.5 percent with lenders such as SoFi and Earnest.
Pros
— Your interest rate isn’t going to change.
— You can account for the payment in an emergency fund in case of a job loss or reduction in income.
Cons
— The interest rate will be higher than a variable rate.
— It can take longer to pay off the loan because the APR starts higher than with a variable rate.
Variable Interest Rate
The variable interest rate is subject to change. In fact, it’s almost guaranteed it will change unless the loan is paid off quickly. Most lenders base their variable rates off a LIBOR rate, which stands for London Interbank Offered Rate and works as a benchmark rate for banks internationally.
As the LIBOR changes, so does the variable rate. At the moment the LIBOR rate is low, which yields low variable interest rates. (SoFi and Earnest both currently offer rates as low as 1.9 percent APR. Earnest will even will allow you to switch between fixed and variable interest rates once every six months.) Once the LIBOR begins to increase, borrowers with a variable rate will experience an increased interest rate. It’s important to ask a lender if the variable rate may increase month-to-month or if it’s locked in for a set period of time before it increases.
Variable rates will have a cap, but the cap may still be painfully high for those trying to dig out of debt. Ask the lender what the cap is before signing any documents.
The variable rate is ideal for anyone who is confident about his or her ability to repay a loan quickly. In this situation, the loan would be relatively low, and it would be unlikely that a job loss or other major expenses would occur during the borrower’s repayment period.
Pros
— Initial rates are currently low.
— It allows for aggressive repayment before rates hike.
Cons
— Rates could increase month-to-month.
— The cap on an interest rate is typically higher than a fixed rate offer.
— It’s difficult to estimate how much to have saved in an emergency fund to cover the cost of the loan in the case of job loss.
Other Qualities to Look for When Refinancing a Loan
It doesn’t matter if you choose variable or fixed — there are ideal qualities in any loan. Borrowers should focus on lenders that offer no origination fee and no prepayment penalty. If a borrower needs a co-signer, then he or she should consider looking for a lender that offers a co-signer release.
There is a variety of options when it comes to refinancing a loan, and unfortunately there are also scams. Be vigilant about doing research to ensure a company is reputable and offers the best possible deal for your situation.
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Fixed or Variable: Which Interest Rate Should You Choose? originally appeared on usnews.com
