FIXED vs VARIABLE INTEREST RATE on STUDENT LOANS: ADVANTAGES and DISADVANTAGES

A large number of students who go overseas for higher education, finance their education cost by borrowing money from banks and lending institutions. The lending institutions which lend money to students charge an interest on such borrowings. These interest rates are determined by banks and the rate of interest depend on a host of factors including the lenders profit margin, cost of operations as well as the monetary policy of the central bank of that country.

While some loans come with a fixed interest rate on borrowing, others charge variable interest rate (also called floating rate of interest). The variable interest rates keep fluctuating depending on macro as well as micro economic factors as mentioned above.

In this blog, Student Cover brings you certain advantages and disadvantages of borrowing money at fixed and variable interest rates.

Fixed Rate of Interest (RoI):

Advantages

1. Not effected by volatility of the economy – Since the rate of interest are fixed for an entire duration of the loan, a person does not have to worry about any increase in the amount of Equated Monthly Instalments (EMI)as they depend on the rate of interest. If the RoI remain constant, the EMI that a student is expected to pay remain the same during the entire duration of the loan. Any measures taken by the Central Bank of the country to control inflation by increasing the lending rate would not affect the borrower.

2. Ensures certainty of repayment amount – Since the EMIs remain fixed for the entire duration of the loan, a student can plan and organize his or her repayment commitment accordingly. The certainty of EMI saves the borrower the trouble of arranging additional sums of money which a borrower might have to arrange if the interest rate increases.

3. Good for economies that witness cycles of high inflation – Since the money supply in the country is checked by the Central Banks such as the RBI, any increase in the supply which ultimately leads to inflation is control by them by increasing the interest rates. Such fixed RoI loans cushion the borrowers whose country goes through periodic cycles of high inflation.

Disadvantages

1. Rates are higher than market prevailing – Since the RoI in case of fixed rate loans remain the same, they are mostly given at rates higher than the existing rate of interest for variable interest rate loans. This is usually done by lending institutions to cushion themselves against the loss in RoI amount due to the increase in cost of borrowing for such institutions due to increase in lending rate by the central bank.

2. Borrowers lose out on lower interest rates – Since the RoI remains the same, borrowers lose out on the opportunity to save money in case of lowering of lending rate by the central bank to encourage investment. Unlike the borrowers of variable interest rate loans, they continue to pay EMI as decided at the time of borrowing.

3. Bad for expansionist economies – Borrowing money at fixed RoI is quite disadvantageous for those living in a country which is following an “Expansionist Monetary Policy”. Such expansionist economies usually reduce lending rates in order to increase money supply in the economy to boost investment and growth. If a borrower has borrowed money on fixed RoI, then he or she loses the opportunity to save money due to reduced EMI because of lower lending rate.

Variable Interest rate Loans:

Advantages:

1. Rates are lower than market prevailing – Opposite to fixed rate loans, the RoI in case of variable interest rate loans are lower. In some cases, the RoI could be 2-3% lower than fixed rate loans. This gives significant advantage to the borrower as he is required to pay a lower EMI on the same volume of loan as compared to the EMI paid by those who borrow money at a fixed rate.

2. Good for economies that are expanding – Those economies which are in an expansionist phase tend to have lower lending rates to boost growth and investment. If a person borrows money at variable RoI, he or she is likely to benefit from successive lowering of lending rate by the Central Bank of that country. Lower lending rates eventually trickle down to individual borrower as lending institutions usually transfer the benefit to the consumers.

Disadvantages

1. Uncertainty of EMI amount – Due to fluctuating nature of the RoI, the borrower might have to struggle to arrange additional amount if the EMI rises drastically due to increase in the lending rate. Unlike fixed rate loan borrowers, the variable Interest rate loan is like a twin edged sword which has its advantages as well as disadvantages. If EMI rises drastically, the borrower faces the danger of EMI default.

2. Effected by volatility and inflation – If the economic condition of the country is very volatile or if the country is suffering from high inflation, then the borrowers of variable rate loan are likely to suffer the most. This is because the measures taken by the Central Bank to reduce volatility and inflation by increasing the lending rate directly affect the EMIs of such borrowers.

Let’s Wrap Up!

While borrowing money to finance higher education, a student has the option to either borrow money at fixed or variable RoI. Both such borrowings have their advantages and disadvantages. While variable RoI helps borrower to save money if interest rates go down, it also negatively impact the borrower when it goes up. The fixed RoI borrower enjoys stability of repayment if interest rates go up but loses out if the Central Bank reduces the lending rate.

Disclaimer: The content of this blog is based on personal research of the writer. Readers discretion is advised. Neither Student Cover nor the writer will be held responsible for any wrongful interpretation of the content of this blog.