NEW YORK (MainStreet) — Students who are contemplating the lower interest rates of variable student loans should consider the potential for paying additional fees over several years.

Most student loan lenders determine the interest rate a borrower will pay based on their credit score, said Andrew Hopkins, vice president of Discover Student Loans, based in Riverwoods, Ill. While variable rates are a good option for some students because the rates are lower than fixed ones, they tend to rise during the term of the loan.

“Unlike federal student loans, the interest rate is not the same for every borrower,” he said. “Students applying with a creditworthy cosigner may receive a lower interest rate.”

Both Libor and the prime rate are benchmark market rates used by banks and other financial institutions. 

The variable rates for Discover’s loans range from 2.99% APR to 9.12% APR or the three-month Libor plus 2.62% to the three-month Libor plus 8.74%. The unknown factor with variable rates is that the three-month Libor rate could increase due to market condition, Hopkins said. The current three-month Libor rate is 0.29%. 

Benefits of Fixed Rate Loans

The fixed rates from Discover range from 5.99% APR to 11.49% APR, also depending on the credit score of the borrower.

“A fixed interest rate is set at the time of application and does not change during the life of the loan,” Hopkins said.

Since a fixed rate loan’s interest rates can never change, fixed rate loans give borrowers “a sense of stability because you know how much you'll pay each month,” Hopkins said. The only time your monthly payment can increase is if the individual choses a period of deferment or forbearance after graduation.

Students should research the APR to compare loan options accurately. The APR represents the annualized cost of credit and includes finance charges such as interest, fees and other charges and whether payments are deferred during school.

“As a result, the APR may be higher or lower than the interest rate,” he said.

Advantages of Variable Rates

While some borrowers are lured in by variable interest rates because they tend to start lower than fixed interest rates, many of them could increase over the life of the loan, Hopkins said. It can be hard to predict where interest rates will be for freshman or sophomores after they graduate.

Students along with their parents should consider how a variable rate will impact their budget. Most student loans have a repayment rate of 15 years and could be a good option for individuals who are confident they can pay off their loan in a shorter period, said Valeria Esparza, a manager for Wells Fargo’s education financial services program based in Minneapolis-St. Paul, Minn.

While some lenders use Libor, others use the prime rate, which is currently 3.25%. In 2005, the prime rate was 5.0%.

Since there is not a cap to the amount of interest that could be paid, a variable interest is a riskier choice, she said.

The variable rates for Wells Fargo loans range from 2.93% APR (with discounts) to 8.60% APR (without discounts) while the fixed rates range from 5.94% APR (with discounts) to 10.72% APR (without discounts).

Fixed rate student loans are a good option for people who want the same interest rate for the life of their loan, while variable rate ones offer the possibility of interest reductions based on changes to the market rates, said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization.

“While a variable rate can help save money as rates drop, the reverse is possible when market conditions send the prime rate up,” he said. “Variable rate student loans are considered most beneficial to consumers when the trend indicates decreasing interest rates while fixed rate loans are the preferred option when rates are on the increase."

Obtaining Discounts

Since the student loan market is competitive, lenders are using various strategies to draw in clients.

Some lenders such as Discover do not charge fees for their loans, so students won’t “incur unexpected fees throughout the life of their loan,” Hopkins said. While many federal loans have origination fees, some private lenders such as Discover do not add them to the cost of the loan. Origination fees are paid by the borrower upfront and will increase the APR and total loan cost.

Many lenders also give discounts for students who receive good grades. Undergraduate and graduate students who earn at least a 3.0 GPA are eligible for a one-time reward equal to 1% of the loan amount of each new Discover student loan.

Students are also eligible for a 0.25% interest rate reduction when borrowers opt to use automatic debit payments after graduation with Discover and Wells Fargo loans. Lenders such as Wells Fargo give another discount of 0.25% if the individual obtained another student loan from them or have another account such as a checking account or auto loan.

Refinancing is a good option once borrowers start working and the current interest rates have started to decline, because many lenders do not charge a fee, Esparza said.

“Since this is a critical time in their life and students will have lots of questions, they should explore all options,” she said. “Wells Fargo has free student loan consultants who can speak to them directly.”

Borrowers who sign up for the new multi-year option at Citizens Bank, the Providence, R.I. financial institution, only undergo the entire application process once. The catch is that it offers rates of 2.68% to 9.43% for undergrads without discounts only if they opt for variable interest rates. The current fixed rate without discounts is 5.75% to 11.75%.

“In general, we have about a 50-50 split on customers who select fixed versus variable,” said Brendan Coughlin, president of auto and education finance at Citizens Bank. “Borrowers will likely save money since the range of the variable interest rates offered is lower than the range of fixed interest rates.”

Borrowers have some flexibility as they continue their education and can opt out in subsequent years.

“If a borrower was approved for $10,000 a year for four years, but after their second academic year, the Libor rates have increased beyond their comfort level, they are under no obligation to take the remaining funds and can very easily apply for a fixed rate loan for the next academic year,” he said.