Fixed Rate or Adjustable for a Student Loan?

Dear Dr. Don, Which student loan option should my daughter take: a fixed-rate loan at 6.25% over 10 years for $20,000, or an adjustable-rate loan for the same amount, initially priced at 2.75%, over 10 years and tied to the one-month Libor?

Obviously, much can be saved with the adjustable-rate loan as it stands now, but there's the chance that this could change down the road. What would you recommend?

Thank you, -- Brian Baccalaureate

Dear Brian, For you to be worse off in the adjustable-rate loan, the average loan balance has to be subject to an average interest rate of more than 6.25%. For an amortized loan -- paid off in regular installments -- that's not all that likely, given today's interest rate environment. I'd pick the adjustable-rate student loan.

Lots of homeowners are struggling with this decision, too. Do they refinance their adjustable-rate mortgage, or ARM, into a conventional fixed-rate loan, or do they stick with the ARM? What's different about your situation is the relatively small loan size and the much higher interest rate on the fixed-rate student loan when compared to current interest rates for fixed-rate mortgages.

The table below shows the difference in total interest expense, assuming that both loans are amortized loans and that the adjustable rate stays constant over the next 10 years. An amortized loan is one in which the monthly payment is large enough to pay the interest expense and pay off the loan over the loan term.

Even if the loans aren't amortized, you should treat them as if they are, assuming no prepayment penalties, because you want the loans paid off at the end of the loan term without facing a balloon payment.

You're worse off with the adjustable-rate loan if the loan rate goes above the 6.25% fixed rate by enough that you wind up paying more in total interest expense. Currently, there's a 3.5 percentage point difference between the two loan rates. That's a big cushion.

Because you're paying down the loan over time, rising interest rates are applied to a shrinking outstanding loan balance. Even in a rising rate environment, it would be unlikely that you'll pay more in total interest expense on the adjustable-rate student loan.

Having said that, I'll be the first to tell you that I don't know where interest rates are headed over your 10-year horizon. People take on adjustable-rate debt if they're willing to accept the risk that interest rates head higher. Odds are that you'll pay less interest with the adjustable-rate loan, but you have to accept the risk of a rising Libor.

One way to mitigate the risk is to use the difference in the two loan payments -- $33.74 -- to make additional principal payments each month. That would reduce the outstanding loan balance and shorten the effective term of the loan.

I didn't consider the tax deductibility of the interest payments. To the extent that the interest expense is tax-deductible, paying a lower interest rate means having a lesser tax benefit. Taxes, however, shouldn't be the tail wagging the dog in making the decision between the fixed-rate or adjustable-rate student loan.

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