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Does it ever make sense to get a variable-rate student loan?

August 30, 2011: 5:05 AM ET

I'm going to be a freshman in college next year, and I was just given a quote for a private student loan. The fixed rate would be 7.75% while variable-rate loans start at 3.25%. The variable-rate option is so tempting considering that prime rates haven't gone up in three years! Obviously this is question of personal preference, but should I risk it? What would you do? — Eric, Miami

The first thing you should do is find out if there are alternatives to pursuing a private student loan. Private loans should only be considered after you've exhausted all federal loans (as well as grants and scholarships). Interest rates on federal loans tend to be better: the fixed rate for a subsidized Stafford loan is 3.4%; unsubsidized, it's 6.8%. Federal loans also have better consumer protections should you have trouble repaying.

These protections make it worthwhile to consider a federal PLUS Loan (a loan taken out by parents), which currently carries a fixed interest rate of 7.9%, before entering the private loan market, says Mark Kantrowitz, publisher of the education-funding site Fastweb.com. In fact, if you need to do substantial borrowing in the private loan market, you may be going to a school that's too expensive, he warns.

But if a private loan is what stands between you and college, the good news is that competition in this market is heating up. Rates have come down and a couple of lenders (Wells Fargo and U.S. Bank) have introduced fixed-rate options in addition to widely used variable-rate loans. Which option is best depends on a variety of factors, including the outlook for interest rates and your personality type. With a fixed rate loan, your first payment can be the same as your last. With a variable-rate option, your payments will grow over time if interest rates tick up. So you need to be comfortable with that uncertainty and confident that you'll be able to afford the higher costs.

Before signing on the dotted line, try to calculate what your monthly bill will be. (Not easy with a variable rate, but play with scenarios.) And pay attention to fees. At the very least, it will be a good motivator to hit the books hard and land a sweet job upon graduation.

-- Stephanie AuWerter

Posted in: Family Money
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