Rishabh Goel - March 28, 2018
Education loans are a life saver for many international students who can’t afford a university’s cost of attendance through their own means. When choosing an education loan, it’s vital to make an informed decision on all of the applicable loan terms.
One of the most important things to take into consideration is the interest rate.
Almost all education loans offer variable interest rates, so it’s important to understand why global lenders use variable rates and how they’re formulated.
Variable rates are used by various lenders across the globe such as Discover Financial Services, Inc. in the US, HBSC France SA, the Royal Bank of Canada, and the State Bank of India.
Sallie Mae, a well-known and respected lender in the United States offers both variable and fixed rate options. And, while the Annual Percentage Rate (APR) for both appears to have the same maximum, the variable rate has a lower end that's more than 2% less than the fixed rate. Indeed, the lender makes it clear on their loan information page that interest rates for the fixed rate repayment option are higher than for variable interest rate loans.
Financial Institutions like to lend over a base rate so that they can assess (and price) the borrowers credit-worthiness independent of market fluctuations.
A popular choice in world capital markets is the London Interbank Offer Rate (LIBOR), where the base interest rate reflects the liquidity of the market and is used as the baseline. Lenders could use other variable rates such as Prime Rate or Marginal Cost of funds-based Lending Rate (MCLR), but all of them are variable and reflect the mood of the economy.
For education loans, international lenders typically refer to LIBOR. In addition to the transparency of LIBOR rates, the primary reason for using this base rate is their worldwide acceptability.
A variable interest rate consists of a fixed margin and the base rate (that can vary):
To truly understand your interest rate, you should ask your lender about the base rate as well as the fixed margin applied.
Prodigy Finance sources its funds over the 3-month LIBOR which reflects in your loan as the base variable rate.
There are different 3-month LIBOR rates dependent on the currency used (US Dollars, Sterling Pounds, and Euros). At the moment, Prodigy Finance lends in US Dollars, Sterling Pound, and Euros.
Many education loans have variable interest rates (unless explicitly stated as fixed). Some of the key benefits of variable rates are:
If the central bank (of any country or market, as in the case of the Euro) wants to encourage consumption, they cut rates and encourage lending to stimulate borrowing and spending. If the economy is vibrant and inflation is increasing, central banks will increase rates to decrease consumption, and hence avoid rising prices.
Central banks use repo rates to signal their monetary policy stance to financial institutions.
The transparency of these changes often depends on the frequency and the independence of the calculation.
It’s critical that you understand how base rates change in order to choose the right loan for you.
The main difference between base rate systems is who calculates them:
Prodigy Finance uses the 3-month LIBOR, which is independently determined by financial institutions, and cannot change the base rate at its discretion.
The fixed margin of your loan is determined during your loan assessment and remains constant.
While the institution (or institutions) setting the rates vary, so do the methods used to determine base rates.
1. Prime Rate
Prime rate is the interest rate that commercial banks charge their most credit-worthy customers. The rate is largely determined by the Repo Rate (Federal Funds Rate in US) – the rate at which central banks lends to financial institutions.
Prime is used by financial institutions across multiple countries including the US, Japan, and Canada. It’s primarily used for business loans, and lenders assess their risk on top of Prime.
Prime Rate is also used for personal finance such as mortgage, credit cards, and personal loans.
LIBOR (London Interbank Offered Rate) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It’s determined for five currencies – USD (United States), EUR (Europe), GBP (UK), CHF (Switzerland), and JPY (Japan). London is mentioned in the name as the benchmark is set in London.
LIBOR was created in 1980s by banks as a standard benchmark to to price various financial products. Instead of borrowers swamped with various products from various banks at varying interest rates, banks now have a uniform benchmark – making it easier for customers to make an informed borrowing choice.
The benchmark is determined every day by Thomson Reuters, as it receives submissions from top global banks. LIBOR discards the four highest and the four lowest submissions as outliers, then averages the remaining submissions.
The rate is determined on a daily basis and reflects the liquidity of funds in the market. The most important factor for market liquidity are the monetary policy stances of the central banks.
MCLR is the base rate used by commercial banks in India. Since 1 April 2016, the Reserve Bank of India has directed all scheduled commercial banks to shift to MCLR.
Before MCLR, RBI had concerns whether the Central Bank cuts were passed on borrowers. To develop more transparency in interest rates, the RBI introduced MCLR so banks can link their lending rates to their marginal cost of funds (borrowing rates). RBI’s rationale is straightforward – if you can borrow at lower rates, you should lend at lower rates too.
MCLR is reviewed on a monthly basis, but banks have a discretion to change them as they feel fit. MCLR is determined by each bank, and may differ among different lenders. The RBI is still working to offer more transparency with MCLR.
For now, only commercial banks in India are subject to MCLR. NBFCs are free to set their own proprietary base rates that they can change as per their discretion (which may or may not reflect market fluctuations).
SELIC is the abbreviation for Sistema Especial de Liquidação e de Custódia and is the base rate based on which private and public banks in Brazil calculate their own interest rates.
Therefore, if the government decreases the SELIC rate, consequently banks must decrease their rates too - and the other way around.
The Monetary Policy Committee called Copom (Comitê de Política Monetária) defines a target every 45 days, and the rate changes on the daily basis as per the target. In practice, however, loans are usually provided at rates over the target.
Variable interest rates are especially useful for borrowers as it means a loan can be secured when needed (for a new home, education, or car) even when the base rate is higher – they won’t be locked into that rate forever.
But, while variable rates allow borrowers to take advantage of lower interest rates when they’re available, they also lend a certain sense of uncertainty - by virtue of not being fixed.
To understand how rates may fluctuate, you could look at financial news to forecast potential movements. However, when banks set base rates, they understand the impact all the financial news in their assessment. Base rates incorporate all currently available information about the present and the future. Your future base rate changes as new information becomes available, and past movement and trends aren’t used to predict its future movement.
A great example is the recent demonetisation exercise in India. Under the exercise, high value currency notes were scrapped overnight, encouraging people to deposit their cash into banks. Banks, expectedly, had excess cash reserves they then sought to lend to borrowers.
To encourage lending, banks cut their MCLR; it was provided to new borrowers and also to existing borrowers with variable rate loans.
While it’s possible to use these indicators to form an idea of interest rate direction, it’s not always necessary to do so.
The purpose of this blog is to provide general information on variable interest rates, as it may be applicable to loans. This blog and its contents do not constitute financial advice directed at any particular person.
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Rishabh Goel is the Country Manager for India at Prodigy Finance. He has a Bachelors in Mechanical Engineering and Masters in Economics from the Birla Institute of Technology & Science, as well as a Masters in Management from London Business School. He has previously worked at TransferWise, and is passionate about borderless fintech.
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