Many student loan borrowers could save money by refinancing their loans, but they don't know where to start. To help educate borrowers, I've put together a series of pieces on topics important to understanding student loan refinancing.
In this first piece, I will cover the two types of rates that borrowers can choose when refinancing their loans: fixed and variable.
What Are Fixed and Variable Rates?
The interest rate on a fixed-rate loan never changes, which means that the borrower's monthly payment will always be the same. Because inflation slowly erodes the value of the dollar, it gradually gets easier to make the same monthly payment be as a loan matures. Assuming that your income grows with inflation, a $300-a-month loan payment will be less of a burden 10 or 20 years from now than it is today.
Loans with variable rates will increase or decrease periodically based on changes in rates charged by large financial institutions, mainly LIBOR (the London Interbank Offered Rate). This also means that monthly payments will fluctuate, which can be stressful if those payments start taking a bigger slice of your paycheck.
Pros and Cons
Both fixed and variable rates have pros and cons.
Fixed rates are undeniably the most predictable of the two—the pro being that the loan's total repayment balance and monthly payments won't change. A con, at least currently, is that fixed rates tend to be considerably higher than variable rates.
The greatest pro for variable rates is that, at the moment, they are near historic lows. The con is that variable rates are sensitive to changes in the economic environment. On Dec. 16, the Federal Reserve raised its target for short-term rates—the first time it's done so in a decade. Any future increases will depend on whether the Fed sees inflation as a threat.
Although there's often an upper limit on how high variable rate loans can go, rates can fluctuate greatly over the lifetime of the loan.
Which Is Right For You—A Fixed Or Variable Rate?
There is no "right" answer here. Rather, it depends on a borrower's personal financial situation and also his or her willingness to take risks.
Fixed rates allow for peace of mind and certainty—for many with hectic lives or less than certain financial footing, this is what best suits their needs. Borrowers planning on paying off their loans in a short amount of time, for those are willing to keep careful tabs on rates, may benefit more from a variable rate loan.
When it comes to student loan refinancing, the most important thing for borrowers to know is that they are in the driver's seat. It is their duty to research to determine what is best for their personal situations.