When you get ready to head off to college, planning how you’ll finance your education is one of the primary steps. If you’re like the 43.2 million student loan borrowers in the United States, chances are you’ll take out loans to help.
But before you sign up to borrow funds, you should understand the ins and outs of interest rates, and how they factor into the cost of your loan:
- What are interest rates, and how will they impact my loan?
- What is the difference between fixed interest rate and variable interest rate loans?
What is an interest rate?
Simply put, your interest rate is how much a lender charges you to borrow money. This number is often expressed as an annual percentage rate, or APR, determined by factors like the type of loan and your credit rating – though not always.
But before we get into different rates, let’s take a look at the two types of interest you may run into: simple and compound.
Simple interest rates represent a fixed percentage of the principal loan amount borrowed, multiplied by the number of payment periods. The basic formula for a simple interest rate:
I (interest) = P (principal) x r (rate) x t (time periods elapsed)
Compound interest rates, on the other hand, add (or compound) interest to the principal sum of a loan or deposit – in other words, paying interest on interest your loan has accrued. The formula for compound interest rates looks like this:
I (Interest) = P (principal) x (1 + (r (rate) / n (number of times interest applied per time period))n x t (time periods elapsed)
Types of Interest Rates
Now that we know the difference between simple and compound interest rates, we can look at three major types: APR, LIBOR, and SOFR.
APR stands for “annual percentage rate.” Your APR is expressed as a percentage representing the yearly cost of borrowing money, including fees or additional transaction costs. (But it does not take into account the effects of compounding.)
As a student loan borrower, knowing a loan’s APR is useful as a tool to compare the terms of two loans. For instance, if one lender offered an APR of 5.7% while another promoted an 8.9% APR, you’d know that a loan from the second lender would cost more in the long term.
LIBOR, or the London Interbank Offered Rate, is the estimated rate that international banks use to lend between each other for short-term loans. This benchmark index provides a backbone for other lenders to set interest rates, including student loan lenders, credit card companies, and mortgage firms.
However, LIBOR has come under fire since the 2008 market crash due to questions of accuracy and rate manipulation. As such, LIBOR is set to be phased out by 2023 in favor of SOFR.
SOFR stands for “Secured Overnight Financing Rate.” The SOFR Index is another benchmark interest rate that banks use to price USD-based investments and loans.
Because SOFR is based on the actual cost of borrowing money overnight, it’s considered both more accurate and resistant to manipulation. And while the transition from LIBOR to SOFR will take some adjustment, it’s estimated that most borrowers will see only a marginal rate change, if any, after the switch.
Fixed vs. variable loans
Another important consideration when choosing a loan is whether the lender offers fixed vs. variable loans.
Loans with variable interest rates carry rates that – like the name says – vary over time. The interest rate fluctuates with market rates and the underlying benchmark or index (such as LIBOR or SOFR) to which it’s pegged.
By contrast, fixed interest rate loans carry one rate for the life of the loan. This rate is usually set at the current market rate plus a spread, based on factors such as the borrower’s credit rating.
When you’re comparing fixed vs. variable loans, you may notice that variable loans have lower rates upfront. This can be a great deal for borrowers on shorter-term loans – but if the interest rates rise during the loan term, your payments will increase, too.
As such, when you’re contemplating which to choose, consider:
- Your loan term
- Your starting interest
- The current interest rate market (especially during periods of volatility)
- If your budget could handle higher payments if interest rates were to increase
Understanding Interest Rates is Important for Borrowers
Preparing for college can be a lot of work, but searching for the most favorable interest rates can save thousands of dollars in the long run. Additionally, choosing between fixed vs. variable loans is crucial to understanding your obligation, once it’s time to start paying it all back. Having a clear understanding of your terms might be key to finding the ideal loan for your particular financial situation.