How Variable Rate Student Loans Work (Pros & Cons)

Written by: Kristyn Pilgrim
Updated: 5/28/20

When exploring your student loan options, you may hear the term “variable rate” or “floating rate.” Unlike a fixed rate loan, variable rates can fluctuate. While more risk is involved in this type of loan, you also have the potential to save money over time on interest costs. Discover how variable rate student loans work and the pros and cons to determine if this is the right pathway for you. 

What Is a Variable Rate Student Loan?

A variable rate student loan is exactly what it sounds like – a student loan with interest rates that can vary. Throughout the lifetime of the loan, its interest rate will be adjusted based on what the market dictates. Since the interest rate can change, monthly payment amounts can fluctuate as well. 

Are Variable Rate Student Loans Private or Federal?

All federal student loans are fixed. Private lenders are the only providers that offer variable rate student loans. However, private lenders can also offer a fixed rate option. Those considering private lending will likely be faced with a decision between fixed and variable rate student loans. Prior to 2006, federal loans included variable options, as well. However, since the federal government does not consider your personal credit risk, all loans are now calculated at the same fixed rate for every individual each year. 

How Are the Interest Rates Determined?

The current financial market dictates interest rates. Often, private lenders will determine and raise interest rates according to the London Interbank Offered Rate (LIBOR). The concept behind LIBOR is to create an average rate calculated from estimates submitted by the world’s leading banks. The rate is essentially what major banks would charge one another in interest if they borrowed from each other. Utilizing this international standard to determine a current rate allows the variable term loan to be a fair option. 

While LIBOR is used as a baseline, lenders will also add a fixed margin to guarantee a certain level of profit, and then an additional percentage will be tacked on based on your creditworthiness. All private lending is credit-based, so lenders will review your credit history before providing an offer.

How Interest Accrues on Student Loans

Another factor to consider when planning for student loans is how interest and capitalization impact the total cost of your loan. When you pay off your student loan debt in full, you will have paid more than the amount you borrowed. Interest begins accruing on the first day the loan is dispersed and continues to accrue until the loan is paid in full. Capitalized interest is another way your total payout amount can increase. At certain periods during the life of the loan, such as at the end of grace periods, the unpaid interest can “capitalize.” This means that the unpaid interest at that point is added onto the principal, and interest is then charged to that new amount. You can help avoid capitalized interest by paying the accrued interest before these grace periods, like at the end of forbearance or deferment. 

Pros of Choosing Variable Rate Student Loans

Variable rates tend to start lower than fixed rate student loans. 

This can mean lower payment amounts in the beginning. A variable rate loan typically has an interest rate that starts lower than a fixed rate loan, which can make a slight difference in your personal budget every month. For every $10,000 borrowed, for example, saving 1.25% in interest would mean a $10 to $12 lower monthly payment.

Variable rates can be beneficial if trends forecast lower rates. 

While it is impossible to predict the future, a variable rate loan can be a good decision when it seems like rates will remain low. Another way of looking at it is if you follow past trends and the rates continue to rise, it may be a smart option to get in while the rates are lower. 

This type of loan may line up well with your career progression. 

Most college students expect to grow their careers after graduation and in the years to come. According to one study, full-time employees with a bachelor’s degree tend to make more money in their 40s and 50s than in their earlier working years. So, if a lower payment is more feasible now, and you can hope to make more income in the future, a variable rate loan may be a great fit for you.

Variable rates can work well with shorter repayment plans. 

If you have a two- or five-year repayment plan, for example, you lower your risk of experiencing significant interest increases due to the shorter time span. While shorter repayment plans mean higher monthly payments, if you know you can pay them off quicker, you can save a lot of interest.

You could potentially receive a lower interest rate during the life of the loan. 

While the idea of a fluctuating interest rate can cause alarm when an increase is expected, there’s still a chance that your rate could be lower than the fixed rate, helping you save money.

Cons of Choosing Variable Rate Student Loans

The risk is greater than a fixed rate. 

While you can save money on interest with a variable rate student loan, you could also end up paying more overall. The risk that interest rates will increase will always be there, and, in turn, your monthly payments will rise too. 

The change is not predictable, making it more challenging to plan for future expenses. 

While the lender cannot randomly start charging you more whenever they want, rates can change monthly, quarterly, or annually, depending on the lender. This impacts the total cost of the loan, as well as your monthly payment amount. An unplanned shift in your monthly expenses can sometimes be challenging to accommodate. 

This type of loan may not be best for longer-term repayments. 

The best way to capitalize on the savings associated with variable rate student loans is to choose shorter-term repayments and pay them off quickly. This reduces your risk of getting hit with higher interest rates over the course of the loan. If you think you will need one of the longer-term options for repayment, there may not be enough of an advantage in savings for you to pursue a variable rate. 

Tips for Proceeding With a Variable Rate Student Loan

If you do decide the best option for you is a variable rate student loan, you can still proceed with caution and make smart decisions. Some lenders provide a cap on the interest rate, which can make it easier to predict your maximum monthly payment. If you are confident you can live with that payment amount at its highest rate, then the risk of a variable rate loan is less intimidating. 

Even if your lender does not offer a maximum rate, you can play around with the numbers and calculate maximum amounts based on past trends. It is a good idea to look at not only the potential monthly rates but also the potential total cost of the loan considering potential rising interest costs. 

Proceed Cautiously With a Variable Rate Student Loan

When evaluating the potential cost of a fixed rate versus variable rate student loan, consider your personality type and your comfortability with uncertainty. What is most important to you in choosing a loan type? If you prefer consistency and predictability, a variable rate loan may not be the best choice for you. If you can see the potential to save enough money for the uncertainty to be worth it, you may be a good candidate for a variable rate student loan. 

For more information on choosing the best student loan option for you, the experts at College Finance have created resources and guides to help you find the best pathway. We want you to get the most out of your college experience by making informed decisions about college education financing.