(Albany, NY: Aug. 2, 2011) As students and parents review their college bills, they may be considering a private education loan to close the gap between college costs and available financial aid. Private loan terms vary from lender to lender, sometimes widely, so it’s important for borrowers to consider their loan choices carefully. Which lender? What sort of repayment plan? And, one of the most vexing choices for some borrowers – choosing between a fixed or a variable rate loan? How does a borrower decide?
The New York State Higher Education Services Corporation (HESC) advises students and families to consider all their options carefully before securing a private loan, and only after exhausting all available federal, state and institutional aid.
With a variable rate loan, the interest rate can fluctuate as often as every 3 months over the life of the loan. As a result, loan payments will vary as market interest rates vary – rising when market rates rise and declining when market rates decline. If rates fluctuate materially, the effect on a borrower’s household budget can be substantial.
With a fixed rate loan, the interest rate is constant. As a result, loan payments remain stable and predictable for the life of the loan. Rising rates will not cause a strain on a borrower’s household budget.
Choosing between fixed and variable interest rates can be difficult. Often the initial interest rate on a variable rate loan is more attractive than that of a fixed rate loan with a similar term. But because the interest rate on a variable rate loan can change, comparing initial interest rates is not enough. Borrowers should take a longer-term view, considering how market interest rates tend to rise and fall in cycles.
For example, between 1990 and 2011 the Prime Rate fluctuated between a high of 10% (1990) and the current low of 3.25%. Between 1970 and 1980, the fluctuation was far greater, ranging from a low of 4.75% in 1972 to a high of 21.5% in 1980.*
HESC suggests three factors that borrowers should consider before taking a private loan:
1. Market fluctuations
Before making a choice, borrowers should think about whether or not they would be comfortable with fluctuations in interest rates and the resulting changes in their loan payments. With the possibility of significant rate swings, many borrowers may prefer the security and predictability of fixed loan payments.
2. Loan term
Borrowers should also consider the term of the loan. The longer the term on a variable rate loan the longer the time period during which the borrower must be ready to accommodate fluctuations in interest rates and the accompanying changes to the family budget.
3. Timing
Borrowers are currently enjoying a period of unprecedented low interest rates. When or how much interest rates will change is unknown but history indicates that rates will increase in the not too distant future. When borrowers choose between variable and fixed rate loans, they must remember to factor this into their decisions.
* Source for interest rate figures: US Federal Reserve Board: Daily bank prime loan interest rates. Figures are annualized using a 360-day year or bank interest. Rate posted by a majority of top 25 (by assets in domestic offices) insured U.S.-chartered commercial banks. Prime is one of several base rates used by banks to price short-term business loans.
