My July column at Physician’s Money Digest is about how to choose between a fixed and a variable rate loan. I get this question at least once a week, usually referring to student loans, but occasionally to a mortgage. The older I get and the more risk tolerant I get, the more I like variable loans. It helps that interest rates have been falling my entire life, of course.
I’m looking into refinancing my student loans. Should I choose a variable or a fixed rate loan?
There is a natural hesitancy to having a variable rate loan, because it creates uncertainty in the future. However, it is still often the correct choice in many situations. The real question is not “variable vs. fixed” but rather “variable vs. variable plus an insurance policy.” When you take a fixed interest rate loan, you are essentially paying the lender to run the interest rate risk for you. You are insuring against a rise in interest rates. My general philosophy with insurance is to insure well against financial catastrophes, but to avoid purchasing insurance you do not need because, on average, insurance is a losing proposition. It must be for the insurer to generate a profit from its efforts.
Interest Rate Insurance
So the real question is whether or not you need the insurance. To determine this, look at the worst case scenario by looking at the maximum interest rate that can be applied to the loan. For example, if you need to borrow $100,000 for 15 years, what is the highest the monthly payment might ever be? If that variable loan that is currently 2% can rise to 10%, can you still afford the payments? At 2%, the monthly payments are about $650. At 10%, they rise to about $1,100. If you can afford $1,100 payments, you can afford to take this risk yourself and do not need to buy insurance against it.
The Case for Self-Insurance
If you are already making extra payments on the loan, this risk becomes even lower for several reasons. First, you obviously can afford the higher payments. Second, every bit of principal paid down lowers the maximum payments, since the interest portion of the payment is calculated only on the remaining principal. Third, most fixed rate loans cannot go from their current rate to the maximum in one jump. There is usually a maximum annual increase. So even in a period of skyrocketing interest rates, it may still take several years to reach the maximum interest rate. During those years, the principal is naturally paid down. Fourth, if rates start rising, you can always readjust your financial priorities to throw more money at the loan, or possibly even refinance it. Fifth, money now is worth more than money later. Lowering your payments as a resident or young attending when there are many competing needs for extra cash can be really valuable.
Variable Rate Wins Three Out of Four
There are really only four situations that can happen with interest rates. In three of these, the variable rate loan outperforms. First, interest rates can remain unchanged, in which case the lower interest rate of the variable loan will cost much less than the higher interest rate on the fixed loan. Second, interest rates can fall, causing the variable loan to become even less expensive. Third, the interest rate can have a small or a slow rise, in which case the variable loan still outperforms the fixed loan. Fourth, the interest rate can rise dramatically and/or quickly, causing the overall cost of the variable rate loan to exceed the fixed loan.
Determining the Break Even Point
Let’s say you are presented with a choice between a 3% variable 10-year loan and a 4.5% fixed 10-year loan. The variable rate loan terms are such that rates can go up 2% per year with a cap at 9%. How much can interest rates rise before you lose by taking the variable rate? Well, obviously if the variable rate never goes above 4.5%, the variable rate will win. And if rates don’t go up until late in the loan, the variable rate loan will also win, especially when you consider the time value of money. In order for the variable rate loan to lose, rates must go up a lot and they must do so early. Let’s again assume a $100,000 loan, but assume the interest rates rise as quickly as possible. We’ll simplify things a bit by making only one payment per year, and calculating the entire year’s interest payment off the balance at the beginning of the year. After one year, the variable rate loan has paid $8,723 in principal and $3,000 in interest while the fixed rate loan has paid $8,138 in principal and $4,500 in interest. The difference in wealth, not counting the time value of money is $2,085. In the second year, the interest rate on the variable loan increases to 5%. Despite the higher interest rate, the variable rate loan still comes out ahead in year two as it is calculated on a smaller amount of principal, further increasing the wealth of the variable interest rate loan holder by $505, for a total of $2,590.
In year three, the interest rate goes to7% and the fixed rate loan finally starts to outperform the variable, but only by $1,612, leaving the overall advantage still to the adjusted rate loan despite a rapidly rising interest rate. In year four, the interest rate goes to 9%, and the advantage finally shifts to the fixed rate loan, with a difference in wealth after four years of $4,285.
But what if interest rates stayed flat for 3 years before this process of rapidly rising interest rates began? Then which loan would be better overall? Well, by the time rates start rising the variable rate loan has already built up a “war chest” wealth advantage of $7,687 composed of $4,500 less in interest paid and $1,433 more in principal paid down. Because of that three year head start, even after ten years the adjustable rate mortgage still comes out ahead by over $8,000.
Interest Rates Are Going Up?
Many people are very concerned that interest rates will soon be significantly rising, not only because they are at or near historical lows, but also because the Fed has signaled that it will soon start raising short term interest rates. However, keep in mind that financial pundits have been predicting rising interest rates for 6 years now, while interest rates have continued to fall. Japan has had low interest rates now for over two decades. Interest rates don’t “have to” rise, and there is certainly significant incentive for the US government to keep them low given its own debt. Besides, the market is well aware of the risk of rising rates and the Fed’s pronouncements, so that information is already “baked in” to the difference between available fixed and adjustable rates.
The Bottom Line
An adjustable rate loan will “win” most of the time and the more flexible your financial life the more you can afford the consequences when it does not win. A fixed rate loan can be better, but only if rates rise rapidly early in the life of the loan. The “breakeven point” is usually far later than most borrowers assume without running the numbers. If you can afford the “worst case scenario,” and especially if your loan length is less than 5-10 years, give serious consideration to an adjustable rate loan, whether it is a student loan refinance or a mortgage. Certainly it is worth running the numbers yourself or hiring someone to do so prior to making your decision, rather than making it based on an irrational fear of a rising payment.
What do you think? Do you have a variable or fixed interest rate on your student loans? How about your mortgage? Do you regret your choice(s)? Why or why not? Comment below!