First off, an interest rate is the amount charged by a lender for the use of the money you are borrowing. Broadly speaking, the interest rate is an annual rate you pay on your outstanding loan balance. If you start out with a $10, 000 loan balance at an annual interest rate of 5 percent, you’d expect to pay about $500 per year in interest.
Charging interest is one of the main ways that lenders make money. Additional loan expenses — such as origination fees or monthly service charges — can be factored into what’s know as your effective annual percentage rate (APR).
Private lenders try to charge enough interest to compensate for the fact that some people they lend to won’t pay them back. In addition to pricing in risk of default and other expenses, private lenders try to build in a profit margin that makes them competitive with other lenders.
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Depending on the type of student loan you take out, you may be offered a choice between a fixed or variable interest rate loan.
The difference is simple: the rate on a variable interest rate loan can change over the life of a loan, whereas a fixed rate will remain the same unless you refinance it.
Rates on government student loans are always fixed, and don’t take into account the credit risk posed by the borrower. That can be a good thing if you have little credit history, or would be considered a high-risk borrower by a private lender.
If you have good credit however, you may qualify for better rates from private lenders — particularly once you’ve graduated and are earning a good income.
For variable- and fixed-rate loans offered by private lenders, interest rates will typically depend on the length, or term of the loan, and the perceived credit risk of the borrower. All other things being equal, the shorter the loan term, the lower the rate.
While rates on variable interest loans typically start out lower than those for fixed-rate loans, they are also less predictable. Let’s dive a little deeper.
Pros and cons of fixed vs. variable interest rate loans
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Many college and personal finance advisers recommend that you minimize your college expenses and take advantage of all available aid, scholarships and federal student loans available to you before turning to private lenders.
Since all new federal student loans are fixed-rate, you may never have to contemplate the pros and cons of fixed- and variable-rate loans. But, if you need to turn to private lenders to refinance or take care of additional school expenses, here’s how to weigh a fixed-rate loan vs. a variable-rate loan.
Fixed interest rate loans
Fixed interest rates are usually set at the time of your agreement and don’t change for the life of your loan. The advantage is that you always know how much you will be paying.
The downside of a fixed-rate loan is that you might be passing up the chance to start out making lower monthly payments. Rates on variable-rates loans are lower than fixed-rate loans because you, not the lender, are taking on the risk that rates will increase.
Currently, student loan interest rates are near historic lows, so a fixed-rate loan might be a safe bet. Rates are unlikely to get much lower, and if they go up, the savings you might start out with by choosing a variable interest loan could evaporate.
If interest rates happen to be high when you take out a fixed-rate loan and end up falling, you might be able to refinance your loan in order to take advantage of the savings. But to make refinancing worthwhile, interest rates would have to fall far enough for you to recoup the expenses that you may incur when refinancing.
Variable interest rate loans
Variable rates can either work for you or against you. During tough economic times, the Federal Reserve and other central banks reduce short-term interest rates in the hopes of encouraging lending that can kick-start growth. When the economy shows signs of heating up, the Fed starts worrying about inflation, and policymakers may decide to raise rates in order to keep prices from rising too sharply.
Variable-rate loans are usually tied to base rates, such as the prime rate or the London Interbank Offered Rate (LIBOR), that fluctuate with the economy. The lender will add a margin on top of the base rate that’s aimed at offsetting the risk that the borrower won’t repay the loan and to make a profit.
Basically, the greater your perceived credit risk at the time of the application, the greater the margin (a co-signer can help lower the rate). When central banks make adjustments that raise or lower the cost of short-term borrowing, other rates will follow, including the interest rate on your variable-rate loan.