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For nearly every major credit account I have, or have applied for, the option of fixed vs variable rates are always presented. I've always, almost without even considering, chosen the fixed rate.

Is it ever a good idea to choose a variable rate loan? One situation I can think of right off is if you sign up for the loan today, with the expectation that you're going to pay it off much sooner than the actual length of the loan. Are there any other scenarios that you should seriously consider a variable rate over a fixed rate?


For some specific data to play with, I'm currently in the final stages of accepting a student loan consolidation/refinance contract, and have the option of $300/mo., with either:

  • Fixed: 5.07% over 86mo., or
  • Variable: 3.79% over 82mo.

The total difference over the life of the loan comes to around $1200 -- so basically, as I understand it, I'm essentially paying $1200 insurance to guarantee my APR doesn't increase above the agreed rate. Is there more here that I'm not considering?

  • For your variable rate loan option, how long is the current rate guaranteed, and how fast is the rate allowed to climb? – Ben Miller - Reinstate Monica Jul 18 '16 at 15:04
  • All future payments will vary based on the variable rate at the time but will never exceed $381.74. -- But I'm not seeing immediately where it shows the rate of growth – MrDuk Jul 18 '16 at 15:07
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    So the rate could change monthly, beginning one month after you begin the loan? – Ben Miller - Reinstate Monica Jul 18 '16 at 15:15
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    If you get charged the 3.79% rate for the first month and $381.74 for every month thereafter then you would pay ~$31,220 for the variable loan compared to $25,800 for the fixed one. Please read tuition.io/blog/ultimate-insiders-guide-private-student-loans/… because YOU are the one that has to be educated enough and ultimately responsible for the financial choice that you have to live with. – MonkeyZeus Jul 18 '16 at 19:41
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    You are paying for the fixed rate. If you plan to (or are able to) pay the loan off early, you will be paying for something you will not be using. However, if you take the variable rate, you are assuming the risk that the rates will rise. – David Schwartz Jul 19 '16 at 3:04
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First, let me fill in the gaps on your situation, based on the numbers you've given so far.

I estimate that your student loan balance (principal) is $21,600.

With the variable rate loan option that you've presented, the maximum interest rate you could be charged would be 11.5%, which would bring your monthly payment up to that $382 number you gave in the comments.

Your thoughts are correct about the advantage to paying this loan off sooner. If you are planning on paying off this loan sooner, the interest rate on the variable rate loan has less opportunity to climb.

One thing to be cautious of with the comparison, though: The $1200 difference between the two options is only valid if your rate does not increase. If the rate does increase, of course, the difference would be less, or it could even go the other way. So keep in mind that the $1200 savings is only a theoretical maximum; you won't actually see that much savings with the variable rate option.

Before making a decision, you need to find out more about the terms of this variable rate loan:

  1. How often can your rate go up?

  2. What is the loan rate based on?

I'm not as familiar with student loan variable rate loans, but there are other variable rate loans I am familiar with:

With a typical adjustable rate home mortgage, the rate is locked for a certain number of years (perhaps 5 years). After that, the bank might be allowed to raise the rate once every period of months (perhaps once every year). There will be a limit to how much the rate can rise on each increase (perhaps 1.0%), and there will be a maximum rate that could be charged over the life of the loan (perhaps 12%).

The interest rate on your mortgage can adjust up, inside of those parameters. (The actual formula used to adjust will be found in the fine print of your mortgage contract.) However, the bank knows that if they let your rate get too high above the current market rates, you will refinance to a different bank. So the mortgage is typically structured so that it will raise your rate somewhat, but it won't usually get too far above the market rate. If you knew ahead of time that you would have the house paid off in 5 years, or that you would be selling the house before the 5 years is over, you could confidently take the adjustable rate mortgage.

Credit cards, on the other hand, also typically have variable rates. These rates can change every month, but they are usually calculated on some formula determined ahead of time. For example, on my credit card, the interest rate is the published Prime Rate plus 13.65%. On my last statement, it said the rate was 17.15%. (Of course, because I pay my balance in full each month, I don't pay any interest. The rate could go up to 50%, for all I care.)

As I said, I don't know what determines the rate on your variable rate student loan option, and I don't know what the limits are. If it climbs up to 11.5%, that is obviously ridiculously high. I recommend that you try to pay off this student loan as soon as you possibly can; however, if you are not planning on paying off this student loan early, you need to try to determine how likely the rate is to climb if you want to pick the variable rate option.

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    Variable rates do not mean that the bank can just change the interest rate to whatever they want. The rate will follow some published benchmark rate such as the prime rate or LIBOR, plus an additional amount that is specified in the loan contract. Mortgages are more regulated/restricted/larger than credit card debt, why would mortgages be free-floating but credit cards based on prime plus a constant? – stannius Jul 19 '16 at 20:16
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    @stannius My answer was a little too simplistic phased the way it was. The ARM mortgage terms will specify how the interest rate adjustments are calculated. However, an ARM can have things like an initial discount rate and a floor (minimum) rate, which can give you a below-market rate to begin with and will automatically rise to an above-market rate at the first opportunity, no matter what the actual market does. I've changed the wording of that section to be more accurate. – Ben Miller - Reinstate Monica Jul 20 '16 at 2:46
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Fixed

You are confirming the amount you are going t pay over the term of the loan.

Variable: 3.79% over 82mo. The total difference over the life of the loan comes to around $1200

That is the wrong way to calculate the variable portion. The variable is primarily set with a margin over a certain benchmark i.e. Fed rate. Assuming the Fed rate doesn't change over or only goes lower the variable rate is the one to go. If it rises then your payment will increase. And the margin they take over the benchmark rate may increase, so the total amount you pay might increase too. I would assume a read through the T&Cs should clarify that for you.

Is it ever a good idea to choose a variable rate loan?

Only if you think we are in a low interest rate environment i.e. the economy is in doldrums and the Feds are trying to simulate the economy by decreasing the benchmark rates. And you are sure that the lender isn't going to increase his margins if the rate remains low for quite a substantial amount of time. And I might assume there will be penalties for paying off a loan quicker.

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It all has to do with risk and reward. The risk is that interest rates will rise.

  • with the fixed rate loan, the bank loses the chance to lend the money to someone else at a higher rate.
  • with the variable rate loan, the bank is doing fine, and you're paying more

To entice you to go with the variable, they make it so it is cheaper if interest rates never rise. Your job is to guess whether interest rates are likely to go up or not.

In a first approximation, you should go fixed. The bank employs very smart people whose entire job is to know whether interest rates will go up or not. Those people chose the price difference between the two, and it's sure to favour the bank. That is, the risk of extra payments you'll make on the variable is probably more than the enticement.

But, some people can't sleep at night if their payments (or more realistically, the interest part of their payments) might double. If that's you, go fixed. If that's not you, understand that the enticement actually has to be turned up a bit, to get more people to go variable, because of the sleeping-at-night feature. Think long and hard about your budget and what would happen if your payment jumped. If you could handle it, variable might be the better choice.

Personally, I have been taking "variable" on my mortgage for decades (and now I don't have one) and never once regretted it. I also counselled my oldest child to take variable on her mortgage. Over this century so far, if rates ticked up, they didn't tick up to the level the fixed was offered at. Mostly they have sat flat. But if ever there was a world in which "past performance does not predict future results" it would be interest rate trends. Do your own research.

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    "It's sure to favour the bank". Not on the variable rate. They will add an additional margin onto their fixed rate calculation, because the bank takes additional risk there, and if I understand capitalism correctly, the one taking the risk wants to see a reward, or else he would be dumb to take the risk in the first place. The variable rate means that the bank gets its 3% or 4% margin over their own refinance rate, unless the loan defaults. With the fixed rate, they may even incur a loss although paid back in full, if they gave you 5.8% and the refinance rate climbs to 6%. – Alexander Jul 18 '16 at 19:32
  • The bank will choose the price difference between the two options in a way that works in their favour. They won't offer you a $3000 discount for choosing something they value at $1000. If they offer you a $1000 discount for it, chances are they value it slightly higher than that. As a first approximation. But then they have to add a little to the sweetener because some people won't go variable no matter what you offer them, because of sleeping at night. – Kate Gregory Jul 18 '16 at 20:24
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It is often the case (more commonly in countries other than the USA) that a fixed-term loan has an early redemption penalty, because the lender themselves will incur a cost for settling the loan early, while a variable-rate loan does not. If this is the situation and you think you might want to pay off the loan early, you should definitely consider the variable rate rather than then fixed rate.

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I have an example that may be interesting for your question. My grandfather had a tennis club around 35 years ago, and some other businesses. Some investments went bad and he was heading for bankruptcy due to the tennis club's expensive payments. So he asked to renegotiate a variable rate rather than a fixed rate, even though the interest rates were going up, not down.

The idea was that if the current situation is going to bankrupt you, taking a chance might be better. As an analogy, if you can't swim and you'll drown in 6 feet of water, it doesn't matter that you're taking the risk to go deeper. You might have to take that chance to survive.

He did keep the tennis club in the end but that's irrelevant here. For student loans, if I'm not mistaken, declaring bankruptcy doesn't free you of all their debt, so it may not be applicable.

And this situation is when renegotiating, not when negotiating the first time. because obviously if you're in trouble financially, taking a loan you know you can't repay is suicide.

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The earlier you are in your career, the more willing you should be to take a better opportunity even if it has a short-term financial cost. You go to college even if McDonald's has an opening. After college you may take an entry level job with better long-term prospects even if a higher paying job is available. You may train for some professional qualification.

Having expenses you have to pay limits your flexibility to do this. A variable rate loan that goes up later may give you the freedom to make better decisions early on. Thus in this case it may be worthwhile.

That said - be very wary of variable rate loans. Unless you have iron discipline, they give the opportunity to bury yourself.

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The simple answer is absolutely. With the parameters you quote, if you will pay off the loan in 82 months or less, you will be ahead taking the variable rate. You have put your finger on the important question as well. The higher initial interest is buying insurance against rates rising if you don't pay off the loan within 82 months. I suspect the contract loan term is much longer than that, because otherwise a variable rate does not make sense. You need to assess whether the insurance you are buying is worth the premium. You can look at what the formula for the variable rate would set the rate at today. It is probably somewhat higher than the 3.79%. That will tell you how much rates have to rise to make the variable rate go above 5.02%. Note that if the loan term is around 160 months (and it could well be 180 months, 15 years) you can afford the interest to rise to about 6.2% for the last half and you will still be dollars ahead. It could even rise higher if you discount expenses in the future. You could also hope that if inflation rises to make interest rates rise like that you will get cost of living raises that make this easy to pay.

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Up to some degree, a higher or lower interest rate means a bit less or a bit more money in your pocket. If the interest rate gets too high, you may be in trouble. So you first look at the situation and ask yourself: At what interest rate would I be in trouble?

If this is a $20,000 student loan, then even a very high rate wouldn't be trouble. It would be unfortunate and unpleasant, but not fatal. For a $800,000 mortgage, that's different. Each percent more is $8,000 a year. Going from 3% to 10% would change the interest from $24,000 to $80,000 a year, which would be fatal for many people.

In a situation where you can afford increasing variable payments without problems you can go for it. If your variable rate would vary over time between 4% and 6% you would still be even. In that situation, go for variable (taking into account where you think interest rates will go in the future). For a mortgage, the security would likely be more important. (On the other hand, if your dad is a multi-millionaire who would help you out, then that big rate increase wouldn't be fatal, and you could go for a variable rate mortgage).

In some countries, you can cancel any loan contract when the interest rate is raised. So raising a variable mortgage interest rate would allow you to look elsewhere without early repayment penalties. Check out if that is the case for you.

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What's going on here is that the variable rate loan is transferring some of the risk from the bank to you. In a reasonable deal taking on risk brings with it reward. It's the same thing as deductibles on insurance--they're transferring some risk to you and thus your expected total cost goes down.

Thus the proper evaluation of such deals is whether you can afford the outcome if you draw the short straw. If you feel you can afford the highest payment that can result then the variable rate is a good deal. If you're near your limit then stay with the safe option of the fixed rate.

For a house this is easy enough to evaluate--run the calculations assuming the highest payment and see what the debt-to-income ratio is. Note that when we were getting mortgages there was another factor involved: the variable rate loans had a higher initiation cost. Combined with the very low difference between fixed and ARM rates at the time we went fixed but given the rates you quote going variable would have been a no-brainer for us.

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