What I didn’t include last week was a note explaining that the 3.4 percent was a variable interest rate.
Let’s talk about that now.
What’s a variable interest rate?
Where most loans you’re used to have a fixed rate, a loan with a variable interest rate works exactly as the words would imply — they vary depending on the market rate.
More specifically, my rate increases and decreases relative to the one-month ICE LIBOR benchmark in U.S. dollars.
Officially, ICE LIBOR is the rate at which banks lend money to each other, as collected and reported every day by the InterContinental Exchange. LIBOR is chiefly pushed up and down by the Federal Funds Rate, as set by the Federal Reserve to work toward two goals: keeping inflation in check and fighting unemployment.
Since unemployment has been a problem since the start of the financial crisis in 2008 and ensuing Great Recession, interest rates have hovered near all-time lows. Right now, that rate is around 0.2 percent.
Since that rate is a benchmark for my student loan, it is somewhat inaccurate to say that I’ve got a loan with a 3.4 percent interest rate from SoFi. It would be better to say that I have a loan whose variable rate is equal to ICE LIBOR plus a 3.2-percent fixed rate (that 3.2 percent is sometimes referred to as the margin).
Why this could be dangerous
It should be fairly obvious why a variable rate loan could potentially be very dangerous.
Having a rate tied to ICE LIBOR might sound like a great idea when it’s only around 0.2 percent, but it would be much less fun if it shot up to three or four times that rate. My loan is capped at 9 percent, and if it ever got that high, I’d be paying more than I was before I refinanced.
Why I took the variable rate loan anyway
There were multiple options to consider when selecting my student loan when I applied to SoFi.
I could have gone with a five-, ten-, fifteen-, or twenty-year term. Because I’ve long been on pace to be free of student loan debt by 2019 anyway — and because they offered the lowest rates — I chose a five-year loan.
The next choice was between a 4.7 percent fixed rate loan and the LIBOR plus 3.25 percent variable rate loan I went with.
To figure out which of the two would cost less, I needed to estimate what LIBOR would be over the next five years.
The best way to guess the future of LIBOR is to pay close attention to every statement that comes out of the Federal Reserve (as mentioned earlier).
Another way is to look at interest rate swaps. An interest rate swap is an agreement between two parties who agree to pay each other’s interest on a specified amount of principal. For example, one company might pay the other a fixed interest rate of 1.3 percent for three years on $1 million (Note that the principal of $1 million never actually changes hands). In return, the other company would pay whatever LIBOR becomes.
The reason that interest rate swaps are important is because when a lot of companies are doing them with each other, the prevailing market rate gives a pretty good indication of what the industry believes is going to happen with interest rates in the future.
Based on current Interest Rate Swaps, these are the interest rates I could estimate over the life of my loan:
That’s an average rate of 4.9 percent over the five years. However, because the earlier, lower rates affect a bigger balance that is then paid off, the dollar-averaged rate is more like 4.5 percent. This is less than the fixed rate of 4.7 percent that SoFi offered me.
And one more important thing: If I pay off the loans in less than five years, I’ll spend even less time in the higher-rate stage, lowering my average rate even more.
So, how do you guys feel about variable rate loans?