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.

**Q. **

I’m looking into refinancing my student loans. Should I choose a variable or a fixed rate loan?

**A.**

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!*

I’m all for variable rate student loan refinancing with 10 year or shorter terms through SoFi, DRB, what have you. (PSLF is its own case as you’ve written about many a time.)

ARMs still make me leery, though, and I’d rather overpay a bit for a fixed rate for more certainty down the road.

Rationally, once the student loans are gone then paying down the mortgage very quickly wouldn’t be an issue: this implies that a 10/1 or a 7/1 ARM would be a decent product for me. Since I’m looking at 30 year amortization periods for both ARM and fixed, however (as I want more month to month flexibility), the spread between ARM and 30 year fixed isn’t compelling enough to make me leap.

The spread between a 7/1 and a 10/1 and a 15 year fixed isn’t usually very impressive. My mortgage is on a 15 year fixed, but if I had it all to do over again, I would very seriously consider a month to month ARM. It’s just insurance I don’t actually need since I can afford to self-insure it. It turns out that every mortgage I’ve ever bought I would have been better off with a month to month ARM since interest rates have gradually but continually fallen ever since I bought my first house in 1999. Obviously that may not continue in the future.

I took a variable 10y rate from SoFi. As you note, it just makes so much more sense and interest rates would really have to take off soon for them to win out. This would be reflective of the economy starting to go at a higher pace, and I just cannot see that (or the debt servicing issues that would arise). Nominal, slow, laddered raises? Sure, but nothing drastic as even the minor tightening from the end of QE is wreaking havoc and the global situation doesnt give much credence there either.

For my recent mortgage…I went fixed rate, insurance was worth it as the after tax rate was already so low as to barely be above inflation. I seriously considered doing a 7/1 arm, but just didnt see the point.

I am in full agreement regarding variable rate loans. I would also like to add that the odds of the interest rate rising by 2% a year is very very low.

School loans and mortgages interest rates are indirectly related to the fed rate. It is extremely unlikely for the fed rate to go up more than a tiny fraction of a percent. Therefor it is equally unlikely for school and mortgage rates to go up more than a fraction of a percent. This makes variable rate loans even more attractive.

Article is a good analysis even if it is just talking about the what-ifs and uncertainty which is all there really is to the comparison. The fixed rate being an insurance policy is a good example.

Our home was a 30 year fixed rate of 3.125%. Even the 15 year rate was only a slight discount (~2.8%), and variable rate loans offered no significant savings either (less than a percent). Super easy decision, and it was a bigger chunk of money.

On the other hand, my wife and I refinanced into a variable rate student loan with DRB, 15 year term at 3.48% (adjusted to 3.50 and now 3.52%). If I recall, the fixed options were all something like ~5.25% to 5.99% and beyond. Coming from student loans at the federal 6.8% rate, the fixed rate offerings weren’t all that appealing.

The money we saved immediately with the variable rate student loan justifies the decision, and helps us pay more principal sooner and accelerate the savings. By the time rates might increase beyond that of the fixed offering, our principal will be much lower (thus rate increase is less of a hit) and we will have already saved a ton of money at the lower rate to begin with. And our loan is capped at 9%, so the additional cost over the original 6.8% loans is pretty insignificant anyway. And the plan is to have the note paid off by the time rates ever get that high.

At the time we did the refi, it was looking like low rates were here to stay for at least the next few years. Now Yellen is signaling that rates may begin to rise at September’s meeting, but with uncertainty volatility in the market this might not be true. Whenever the fed does decide to raise rates, it’s going to be a slow trickle up, so it will likely be a significant time before the variable rates hit the previously quoted fixed rates.

I think fixed makes sense if you know you’ll be paying a note for 20 or 30 years, or if you know you simply couldn’t afford to pay at a higher rate. As long as the delta between fixed vs variable is big enough, and your budget can handle the maximum rate, variable is the winner.

As no one knows the future I would go fixed on a home mortgage

NOT IN MY WILDEST DREAMS in l975 did I think I would retire and see 10yr rates at this LOW NUMBER

The fixed=PEACE OF MIND

I think that is precisely the point WCI is trying to make. Paying extra for fixed rate is paying for insurance, aka “peace-of-mind.”

Another thought if the variable rates go beyond the original fix, could you refinance? The fixed probably will have gone upto. I like the white coat have no recollection of high interest rates so if there are people (who have seen the high interest rates) that could chime in I would appreciate it. The rates have only gone down.

Remember I’m not talking about a 5/1 ARM. I’m talking about variable from day one. But yes, if you have a 5/1 ARM you can always refinance, but it might be at a higher rate. There’s no free lunch there.

I like the analysis of the options, and the calculations, but I don’t necessarily agree with the conclusions. I agree with Craig’s post above. I was going to post almost the same thing. I took out a 30 year fixed mortgage in 2001 and was thrilled to get a 7 1/2 % interest rate. That was LOW. As interest rates dropped, I refinanced 4 times, at zero cost each time, into lower fixed rate mortgages. I ended up with a 3% fixed rate which I paid off. At the time of my last refinance, a variable had a higher interest rate and higher closing costs than a fixed. Fixed have the advantage of protecting you from loss if rates go up,but still allowing you to refinance when rates go down. Yes, you pay a bit for that insurance, but you can mitigate the loss by paying off the loan early. If you can pay off early, your loss vs the variable is small. If you can’t pay it off early, then you’re better off with the fixed anyway. If you stretch to buy a house that you can’t quite afford, then you can’t risk a rise in interest rates, and you need to go with the fixed rate.

I remember the 1980’s. Student loans at 12%, and bank CDs paying 18% for 20 years. Interest rates were rising with no end in sight. Right now, interest rates are at unprecedented all time lows, but they will rise soon, so if you can pay off a student loan within 5 years, fine, go with adjustable, but if you will need a 30 year mortgage, I would go with fixed.

On another note, anyone with a loan or a mortgage today should not be buying bonds. If you have a student loan at 6.8%, you probably shouldn’t be buying stocks either, outside of your retirement accounts. Just pay off your loans for a great guaranteed return.

You don’t know they’ll rise soon, at least not significantly. They could stay low for decades. I agree with you that the length of the loan is a big factor and that variable is very attractive for 5 years and fixed is very attractive for 30.

I am a current PGY1 and chose to refinance my loans with a variable interest rate loan from the Bank of North Dakota (Deal One Loan). I went this way because the interest rate won’t match my Federal Rate until I am one year into “attendinghood.” I also felt that losing the PSLF, PAYE, and IBR was worth it because I: 1)wasn’t willing to file “married filing seperately” as we wouldn’t be able to fully fund Roth IRAs, and 2)wouldn’t have qualified for a low payment filing jointly with my wife.

I like the idea of considering a fixed rate loan as paying extra for insurance. I have an ARM and it was a no brainer for me. The initial rate was very low and it’s for 10 years. We plan to live in the house for about 5 years, so unless something crazy happens where we can’t move for 5 more years, I don’t even have to worry about interest rates. So a person’s situation can definitely come into play.

I’m also in the process of refinancing some of my higher interest student debt into a loan with a low variable rate. I chose that because I will be able to make some extra payments and get rid of the loan quicker, so why not go with the lowest rate possible?

I appreciate the article as it encouraged me to start shopping for a variable rate.

I have ~ 100k consolidated with DRB at 5.25% (10 year fixed). I do like the “peace of mind” aspect with a fixed rate. But since I now have nearly 50K in my emergency fund, I’m in the process of consolidating 50K of the fixed rate into a variable. I figured I may as well use the leverage of the emergency fund in my favor.

Had not thought about fixed vs variable much, until I got approved for refinance/consolidation for my student loans from SOFI. Including the auto-pay discount, 3.5% fixed for 5 years vs 1.9% variable with a maximum cap at I believe almost 8%. 8% definitely sounds scary, but 1.9% sounds SO much better than 3.5%

I am not a gambler and I actually do not enjoy it, I played roulette once and lost $50 in not even 2 seconds and have never gambled again, but the idea of paying > 26k in interest over 5 years with fixed sounds terrible.

I hope I make the right decision, but am leaning towards going with the variable, and hopefully pay off faster than 5 years.