Staring at the loan refinance package offered to me by Earnest, I kept looking back and forth between the variable rate and the fixed rate. As a lawyer, my conservative nature meant the fixed rate looked safe. I would never have to worry about interest rate fluctuations. The other half of me thought going with the lower rate made the most sense. In the end, I choose the variable rate. Here’s why I think for most people the variable rate is going to be the better option.
It’s all about risk allocation
The difference between choosing a fixed or variable rate is about allocating the interest rate risk between the two parties. If you accept a variable rate, you’ve agreed to take on the risk of interest rate fluctuation in the future. If interest rates go down, you’ll reap the benefit of taking on this risk. If interest rates skyrocket, you’ll pay the price by seeing the loan on your interest rate rise.
On the other hand, if you choose the fixed rate option, you’re offloading the interest rate risk to the lender. It’ll be on them if interest rates go up or down over time. They may make more money if rates fall and they may see a smaller profit if interest rates rise. Because they’re taking on the risk, they’ve calculated the price of such risk and built that into the rate they’ll charge you. That’s why the fixed rate is higher than the variable rate.
Allocation of risk among parties should be a familiar concept to almost all lawyers. We learned a long time ago that the law rarely yields absolute answers. Instead, there are a lot of gray areas with many possible outcomes. You make the best decision you can, allocate the risk among the parties as appropriate and move on.
Of course, sometimes people don’t want to take on the risk themselves. For whatever reason, they find it unacceptable to deal with the risk. In those cases, a party will often turn to a third-party insurance provider to offload the risk (e.g. think of rep and warranty insurance).
How is this similar to refinancing your student loans? By choosing to offload the interest rate risk to the student loan provider, you’re essentially purchasing an insurance policy that will cover the risk for you. There’s a chance that interest rates go up, in which case your insurance policy will pay off, and there’s a chance interest rates will remain unchanged or go down, at which point your only loss will be the premiums you’ve paid for the insurance product.
Here’s a calculator for you to play with the numbers:
Variable vs. Fixed Interest Student Loan Calculator
Should you buy insurance on interest rate risk?
By calculating the difference between the fixed and variable rate, you’ve come up with the price of the insurance policy you’re purchasing to offload the interest rate risk.
Let’s suppose you have $100,000 of debt and you’re being offered a variable 3.05% rate or a fixed 4.5% rate. Your annual premium is $1,450 ($100,000 X 1.45%) in exchange for insuring against changes in the interest rate.
How does that number feel to you? It seems high to me. That’s over $120 a month to insure against possible movement in interest rates. Worse, you’ll need a movement of over 1.45% before the insurance policy starts to pay dividends to you. If interest rates go up by 0.5%, you’ll pay a smaller premium ($950 vs $1,450), but you’ll still be paying a premium to insure against rates rising above 4.5%.
Generally, I’m not a fan of paying for insurance to cover things that you can self-insure against. For example, everyone knows the extended 2-year warranty the big box retailer is trying to sell you on your TV is a bad deal. Why insure for the possibility of your TV dying when it would be pretty easy for you to replace it out of cash flow (or not replace it!). On the opposite end of the spectrum, disability insurance makes a lot of sense. If you are unable to work, you will see a substantial reduction in your lifestyle if you don’t have an insurance policy to provide benefits.
So, the question becomes whether you think a $1,450 annual premium is worth it to insure against the possibility of interest rates going north of the offered fix rate. But in a perverse twist of fate, the numbers get even stranger. Since your premium is based off your loan balance, the premium is higher specifically during the first year or two after refinancing. Those two years happen to be the years when you have the most knowledge about the likely interest rates. If you pay half the entire account balance within two years, your premiums will be cut in half going forward but you’ll have already committed over $2,900 ($1,450 X 2) towards the policy.
For these reasons, if your plans are to aggressively pay off your loans, it makes little sense to take on the fixed rate and pay for the student loan refinance company to insure you against interest risk. Even if you’re not convinced that you’ll be able to knock out the loans in 2-3 years, the premium you pay at the beginning of the loan will be dramatically high as compared to the later years. Is there a risk that you could come out worse because interest rates skyrocket? Yes. But is that risk worth $1,450 a year? I don’t think so.
Four possible outcomes
As explained in the Student Loan Refinancing Guide, we can break down each scenario and see how someone might do depending on how interest rates change in the future. There are only four possible outcomes:
- Rates Are Unchanged. Rates move neither up nor down as you pay off your loan. The variable rate clearly wins, since you’ll save the premium payments over the life of the repayment. VARIABLE WINS.
- Rates Fall. Rates move down as you pay off your loan. Again, the variable rate clearly wins since you’ll skip the premium payments and benefit from your interest rate dropping line with interest rates generally. VARIABLE WINS.
- Rate Rise Slowly. Rate rise slowly as you pay off your loan. The variable rate will likely win here too. You’ll benefit from the delta between the fixed and variable rate as you’re paying off your loans. Eventually the variable rate will rise past the fixed rate, but by this time you will have made a lot of progress on paying off your student loans. I doubt the extra interest you pay after your variable rate exceeds the fixed rate will be greater than the amount of extra interest you would have paid on a fixed rate up to the point that the variable rate exceeded the fixed rate. VARIABLE WINS.
- Rates Rise Quickly. I think this is the only scenario where the fixed rate wins. If interest rates were to rise quickly, you could find yourself paying more interest than you would have had you taken out a fixed rate loan and that extra interest could overtake the savings you achieved by starting with the variable rate. Rates would need to rise pretty quickly in order to achieve this scenario. Possible? Yes? Likely? I’m not so sure. Many loans are capped at how quickly the rates can rise each year (e.g. 2% annually). If interest rates began rising quickly, you’d likely have some time to figure out an alternative plan such as paying off the student loans faster. FIXED WINS.
If you’re still worried about taking on interest rate risk, consider that you can start with the variable rate and make a choice later to switch to a fixed rate. You can use a tool like Credible to quickly get a sense of the various interest rates (fixed or variable) that are available in the market across different repayment terms. I could see someone switching from a variable to a fix if something drastic happens in your life like a job loss, other financial disaster, birth of twins, etc. I know that Earnest offers you the option to switch between a fixed or variable rate during the course of the loan (up to once every 6 months). If interest rates go up, you won’t get the same lower fixed rate originally offered, but this should be enough to get you comfortable that you won’t end up in some financial circle of hell where you did the right thing by going with the variable rate but met with an unexpected financial disaster, had to delay repaying your loans, watched interest rates skyrocket and are somehow stuck paying off 15% student loans. I know the conservative nature of lawyers means that we should consider that possibility, but I think it’s highly remote. Go with the variable rate.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He is always negotiating better student loan refinancing bonuses for readers of the site.