By Joseph Reinke, CFA
Often times when we refinance our student loans, we ask ourselves one simple question: Does refinancing save me money? The marketing geniuses at lending companies also know this and is why you see student loan refinance advertisements with big bold words saying how much an average person saves. However, the decision is not that simple, especially when considering variable rate student loans.
Determining when to refinance using a variable rate student loan is a complex topic but we at FitBUX have constructed this easy to understand guide. This guide will take you through four risk factors that will assist you in answering the question: "Is refinancing with a variable rate student loan the right choice for me?"
Below are the four risk factors and accompanying videos. If you would like to discuss your personal situation, join FitBUX today and schedule a time to chat with one of our FitBUX Coaches, its free.
- Risk Factor 1: Current Variable Rate vs. Fixed Rate
- Risk Factor 2: What is the Cap Rate?
- Risk Factor 3: What is the Loan Term?
- Risk Factor 4: What is the Loan Balance?
This is the easiest risk factor to analyze. If the proposed interest rate on the variable rate student loan you are contemplating is greater than your fixed interest rate student loan, then keep your fixed rate loan and go enjoy the rest of the day. Simply put, in today’s interest rate environment, rates will most likely go up from where they are today and there is no upside in sight for you under that scenario.
If the starting interest rate offered on the variable rate loan is lower than the rate of your current fixed-rate loan, you should proceed to the second risk factor below.
All variable rate student loans have interest rates that vary, most do so on a monthly or annual basis. The Cap Rate is simply the highest interest that you can be charged over the life of the loan. For example, if the Cap Rate is 9.0%, then the interest rate you are charged can go up to but not higher than 9.0%.
The Cap Rate is important when deciding to refinance using a variable rate student loan because variable rate monthly payments often times start off being lower than your fixed rate payments. However, if interest rates rise your monthly payment under a variable rate student loan could end up being greater than it would be under your current fixed rate loan.
When evaluating your Cap Rate, there is no "magic" number. For example, one simply can not say “9.0% is too high. Therefore, I should not refinance with a variable rate student loan.” Instead, you must look at the Cap Rate relative to your fixed interest rate.
As a general guideline, if the Cap Rate on the variable rate student loan you are being offered is greater than your fixed rate loan by 1.5% or less, then refinancing into the variable rate student loan would make sense, all else being equal. For example, if your fixed interest rate is 6.0% and the cap rate is 7.5% or lower, then refinance into a variable rate student loan. If, using our example, the cap rate is greater than 7.5% then the variable rate student loan has a high amount of risk and you need to proceed to the third risk factor below.
The third risk factor you need to consider when contemplating refinancing with a variable rate student loan is the term, meaning is your variable rate student loan 2 years, 5 years, or 10 years?
Historically, interest have tended to go up slowly. Therefore, the shorter the loan term, the less likely the interest rate is going to increase dramatically. Thus, if you have a short-term loan, your interest rate is less likely to increase to the Cap Rate.
In general, a variable rate student loan with a term of less than 4 years is considered low risk, all else being . Conversely, a variable rate loan with a term greater than 7 years is considered high risk and you will need to analyze the last risk factor below.
If you are offered a variable rate student loan with a term between 4-7 years, a deeper analysis must be performed and we recommend contacting us for a free student loan analysis.
The last risk factor to analyze when determining if you should use a variable rate student loan to refinance is the size of the loan.
Let's assume you owe $1,000 on a variable rate student loan and the current interest rate on that loan is 2% and the Cap Rate is 8%. Let’s pretend that the interest rate on the loan changes overnight from 2-8%. What would happen to my monthly payment? The required monthly payment only goes up by $2.75. On the other hand, if the amount you owed was $100,000, the monthly payment would increase by $274 a month.
Therefore, the lower your student loan balance is, the lower amount of risk you are exposed to when considering a variable rate student loan. Determining what loan balance is appropriate highly depends on your income level and how quickly you plan on repaying your loans.
In general, if the above risk factors are low and you plan on paying off your loans quickly, you may want to consider refinancing 100% of your loans into a variable rate loan. If the above risk factors are considered moderate risk, you may want to limit your exposure to variable rate loans at approximately 50% of your income. I.e. if you make $100,000 per year limit your variable loan balance to $50,000 or less. If the above risk factors are high risk then you may want to avoid variable rate loans altogether. If you do want to use them we would not recommend more than 10%-20% of your annual income, i.e. you make $100,000 per year your variable rate loan balance would be less than $20,000.
Of course, each situation is different. If you would like us to take a look at your personal situation, let us know. Sign up at Fitbux.com today and use our one-of-a-kind technology to evaluate your situation. Its’ free….