One of the many decisions that you will have to make when choosing a loan is whether you should choose one with a fixed or variable rate of interest. And yes, it does make a huge difference to your monthly payments and to the overall cost of the loan. Before you decide which one is the better option for you, it is important to understand what these terms mean, how they work and what are the implications.
Fixed vs. Variable Student Loan Interest Rates
When you borrow money from any financial institution, whether federal or private, you are expected to pay it back with interest. While the loan terms and conditions may vary widely from one lender to another, the interest rates generally fall under one of two categories, fixed or variable.
When you take a loan with a fixed interest rate, you know that the rate will remain constant throughout the life of the loan, irrespective of market conditions or any other external factors. Federal student loans are fixed rate loans.
With a variable rate loan, the rate of interest varies considerably depending on the market conditions, which means the rate of interest could rise or fall at any time during the life of the loan. Private student loans may have fixed or variable interest rates.
Advantages And Disadvantages Of Fixed Interest Rate Loans
With a fixed interest rate, the rate of interest and the monthly payments remain the same throughout the term of the loan unless you specifically choose the income-driven repayment plan. In an income-driven repayment plan, your monthly payments are pegged to the amount that you earn that month.
The advantage of this is you know exactly how much you have to keep aside for your loan repayment every month. You do not have to worry about how the market is doing. Even if you choose the income-driven repayment plan, your monthly payment only changes if your earnings increase or decrease.
The disadvantage of fixed interest rate loans is that the rate of interest generally tends to be higher than the interest rate on variable-rate loans within the same repayment term.
Advantages And Disadvantages Of Variable Interest Rate Loans
With a variable interest loan, the rate of interest can increase or increase several times over the term of the loan. This affects not only your monthly payments but also the total cost of the loan.
The advantage of variable interest loans is that their interest rates are generally lower than fixed rate loans at the outset, so you know you will start out making lower monthly payments. If the market conditions remain stable or improve, you will continue paying the lower rate, reducing the cost of your loan considerably.
The disadvantage with these loans is that it is impossible to predict your monthly payments over a period of time. It could change overnight if the market conditions fluctuate. Also, there is a possibility that the rate could jump sharply, increasing the overall cost of your loan.
As a general rule, it is always better to first exhaust all your federal student loan options. These are always fixed-rate loans and have lower rates of interest. Regardless of how low the rate is of a variable-rate loan, you should only consider it if you are prepared to take the risk of the rate increasing at any time.
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