Should You Take A Fixed Or Variable Rate Student Loan?

Loan

Hi guys,

Today I want to share a discussion I had with my friend Henry, whose non-picture I have up there in the header. Henry is getting an excellent but ridiculously expensive education. It’s absolutely worth it, because once he’s done, he’s going to be making somewhere in the neighborhood of $200,000 a year, to begin with. So, like many other smart people, Henry is taking student loans to help him pay for that education today.

Henry came to me with a simple question. His private borrower is offering him two different interest rate categories on the money they’ll lend him: a fixed interest rate and a variable interest rate.

They’re exactly what they sound like, the fixed interest rate is fixed, constant, it’s the same percentage throughout the duration of the loan, meaning that Henry knows exactly how much in total it’s going to cost him to carry that loan to term.

The variable rate is not going to stay constant at whatever it is today. The bank may decide tomorrow to charge Henry a different rate from what they’re charging today, moving the rate up and down as much as they choose until the entire loan is paid. In theory, they could pick whatever number, but in practice they tend to follow what the overall interest rates are for the current market at any given time.

Henry wants to know which of these he should take. If you’re thinking the fixed rate is a no-brainer, let me give you a bit more information. The fixed rate, today is at around 6% for the life of the loan. The variable rate is at 4.4% now, but then it could be 9% tomorrow, or 2%. No one knows, really.

Henry wants my advice on which of these to take. Well, the central question here is: do we think the variable rate is going to climb or fall? Let us find out.

Most banks calculate their variable rate through a combination of three factors

1. The current LIBOR (London InterBank Offered Rate)

2. the bank’s own risk premium, and

3. the customer’s risk premium.

LIBOR is the base interest rate for much of the world’s financial system (which tells you all about London’s place in it) so any banking system will more or less mirror it.  Henry’s credit is stellar, as is the banks. So the main constraint now, is LIBOR, whether we think it’s going up, or down.

Here’s a chart of LIBOR from the mid-80s to now.

Libor

If you noticed, LIBOR was already trending lower, and then fell off a cliff in 2007 during the Recession. After years hovering around the zero bound, there’s been that ever so slight uptick in 2015. Based on the projection of economists, and the signals of central banks, we can predict that the trend is going towards higher, not lower rates.

So then it’s almost certain that variable rates are going to climb. How soon will they climb from 4.5% to the 6% and up the fixed rates are at now? It depends. On a lot of other things, continuing economic growth, credit demand, other things. But we know it’s going to get there eventually.

So in the end, I advised my friend Henry thus: if you’ll pay off this loan within the next year or two, opt for the variable rate. But anything longer than that, and I’d be more inclined to go for the fixed rate.

If you’re currently borrowing money for school, or mortgage, it might be useful for you, but this post does not constitute financial advice. It’s just something to think about and make up your mind.

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