How do you weigh a trade-off between short-term rewards and long-term risks? Refinancing a student loan at variable loan rates requires that type of decision, and the key to making a wise choice is to fully understand both the possible benefits and the potential drawbacks.
Possible benefits of refinancing at variable loan rates
Variable-rate loans are based on a market index of interest rates, and they are designed to periodically reset to reflect changes in market rates. Why would you consider this type of refinancing? Here are a couple of reasons:
- Variable rates can be lower than fixed rates. Because variable rates allow lenders to reset the interest rate you pay if market rates rise, lenders are more comfortable issuing these loans at lower rates than if they had to lock in a rate for the life of the loan. Thus, variable rates are often lower than fixed rates. This could allow you to save money when you first refinance, and continue to save money as long as interest rates remain low.
- Your credit standing might be better now than when you took out the loan. When you borrowed money for college, you might have had a limited work history and income. Now, if you are a few years into your career, you might have built up a good payment record and a healthy income stream - things that make lenders view you as a lower risk. That lower risk might qualify you for a lower interest rate. This would be true of fixed or variable interest rates, but the potential to reduce rates is greater with variable rates.
Potential drawbacks of refinancing at variable loan rates
Balanced against the possibility of lowering your interest rate are the following risks that come with variable rate loans:
- Rising rates. If market interest rates rise, the interest on your loan will increase. That would increase both your monthly payments and the total amount of interest you pay over the life of the loan. Thus if rates rise, refinancing at variable loan rates could be more costly in the long run, and could make it more difficult to afford your monthly payments.
- Giving up the repayment protections of government-backed loans. Variable-rate loans are offered by private lenders, and if you are refinancing out of a federally-backed student loan, you might be giving up some important benefits of government loan programs. These include limits on how much of your income your payments can represent, and even loan forgiveness under certain circumstances.
- A longer repayment period could cost you more in the long run. When refinancing, there is often a temptation to lower your monthly payments by refinancing into a longer-term loan. Be advised, though, paying interest over a greater number of years could result in your paying more interest over the life of the loan, even if your interest rate is lower.
Key factors in managing the risk of variable loan rates
When considering the risks and rewards of variable-rate loans, it is important to understand how the following factors can impact the level of risk:
- The reset period. This determines how frequently the interest rate will reset, both initially and then over the remaining life of the loan. The longer the reset period, the less frequently you would be exposed to the risk of rising interest rates.
- Your repayment schedule. The sooner you can repay the loan, the less time there would be for higher interest rates to have an effect. So, refinancing into a fairly short-term loan could reduce the potential impact of variable rates. Also, if you can build up the means to pay off your loan early, you could keep to the regular payment schedule as long as rates are in your favor, but then pay off the loan more quickly if rates start to go against you. Just be sure to look into any prepayment penalties that might apply before you choose the early repayment approach.
Taking on debt at a variable loan rate means having to play "what if." Think about what would happen to your loan payments if rates were to rise, and only if you are comfortable that you cold cope with that risk should you refinance your student loan at variable loan rates.