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What is the difference between Fixed Rates or Variable Rates?

Jose Espada • 10/26/12

It’s good to have options, but what is the reality when it comes to student loans.  The reality is that federal student loans interest rates are fixed.  Private Loan interest rates are variable rates.  So, what’s the difference?      

A fixed rate is generally higher than a variable rate loan and remains the same over the life of the loan, which means your monthly payments remain stable over time.  A variable rate is initially lower than a fixed rate and may rise or fall as the Prime Rate or London InterBank Offered Rate (LIBOR) adjusts over time, which means your payments may vary on a monthly basis.  Generally, variable interest rates may be higher than a fixed rate as you have the loan over time.

What is a floor rate?  A floor rate is the lowest that a lender can charge you – even if the Prime Rate drops lower than that.  So for example, maybe your lender set their floor rate at 3.00%.  If the Prime Rate goes down to 1.00%, you may still have to pay the higher rate of 3.00%, because that’s the floor rate your lender has set.  Fixed rates are not affected by floor rates.

So, how is an APR different than an interest rate?  What you are charged for your loan isn’t actually just an interest rate, it’s really the Annual Percentage Rate (APR).  You have probably seen the term “APR” related to loans such as car loans and credit cards.  So what does that mean?  The Apr is the annual cost of your loan.  It includes the interest rate and certain fees.  If your loan has a variable interest rate, the APR will also increase based on how much your interest rate fluctuates.

With some student loans, one major thing will cause the APR to be different than the interest rate and this is deferment periods.  During a deferment period you are not making payments on your loan, for example while you are in school and during your grace period.   Deferment periods can cause the APR to be lower than the interest rate.  Why?  The APR is calculated under the assumption that interest is capitalized (added to the principle balance).  However, if your lender does not capitalize the interest for your student loans during in-school deferment and grace periods, your APR goes down.

So, what does this all mean?  In general, federal student loans are fixed rates and nothing changes.  It does not vary according to the market.  It stays the same until the loan is paid off.  In the private loan industry, interest rates do change according to the market and are further influenced by periods of non-payment or deferments.  Interest rates can be complicated.

Author

Jose Espada

Jose Rivera Espada is the director of financial aid at IU School of Medicine, a nine-campus allopathic medical school in Indiana. Jose’s experience includes working as an assistant director of financial aid at Butler University and a financial aid counselor at Indiana University in Bloomington. He has served on various committees at the Association of American Medical Colleges (AAMC) as well as state and regional financial aid organizations. He speaks regularly about financing medical education at colleges and universities throughout the state of Indiana. He earned an undergraduate degree from Indiana University and worked toward a master’s degree in music education before finding financial aid as a profession. He performs regularly with small professional choral ensembles in the Indianapolis area.