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.
Why global lenders use variable interest rates
Financial Institutions like to lend over a base rate so that they can assess (and price) the borrowers creditworthiness independent of market fluctuations.
A popular choice in world capital markets is the 3-month CME Term SOFR (SOFR), 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.
How variable interest rates are formulated
A variable interest rate consists of a fixed margin and the base rate (that can vary):
- Fixed margin: Fixed margin is a set rate determined during the initial loan assessment. Your financial health determines your fixed margin; it’s based on the likelihood of timely loan repayment according to the information you provide the loan provider (the information required varies between countries and institutions). Once set, your fixed margin does not change over the tenure of the loan.
- Base rate: This is the portion of your variable rate that varies; as the base rate changes, your variable interest rate adjusts accordingly. Base rates are benchmark rates that allows lenders to determine credit worthiness as a spread (fixed margin) over the base rate. There are multiple base rates (such as SOFR, Prime, MCLR, SELIC, and Euribor) and currency is a key determiner for the one used.
**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 SOFR which reflects in your loan as the base variable rate.
The benefits of variable rates
Many education loans have variable interest rates (unless explicitly stated as fixed). Some of the key benefits of variable rates are:
- Variable rates pass on the benefits of initially low interest rate, or potential future rate cuts to the borrowers.
- They insulate investors from unpredictable market fluctuations.
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.
Why the transparency of variable rates is important
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.
How base rate changes are typically calculated
The main difference between base rate systems is who calculates them:
Independent financial institutions: Some base rates are determined independently – and lenders that use them cannot change these base rates which makes them very transparent. Examples of these base rates include SOFR, Euribor (EU), and Prime (US/Japan).
Commercial Banks: Bank rates can be linked to central bank rates in the countries where they operate, such as SELIC (Brazil) and MCLR (India). These base rates are subject to periodic reviews by lenders, though rates aren’t independently determined.
Non-banking financial institutions: Other proprietary base rates are determined by non-banking financial institutions (NBFCs). In some regions, these can be changed by lenders at any point in time.
Prodigy Finance uses the 3-month CME Term SOFR, 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.
Let’s take a closer look:
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.
SOFR (Secured Overnight Financing Rate) is the secured overnight interest rate for US dollar-denominated loans and is published by the New York Federal Bank. SOFR is the recommended replacement benchmark rate of the US and UK financial authorities for USD LIBOR. The 3-month CME Term SOFR is a rate index based on what the market expects rates to be over the next three-month time period and is the recommended benchmark rate that will replace USD 3-month LIBOR at the end of 2021.
Follow this link to CME’s website to find out more on 3-Month CME Term SOFR. From the start of 2022, Prodigy Finance will begin using this benchmark for all new loans denominated in US Dollars to comply with financial regulation
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.
Can you forecast base rates?
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.
Key points to remember when choosing a loan
- All interest rates are variable, unless specifically mentioned as fixed. If you’re unsure, ask your lender to clarify before taking a loan, so you can truly compare different offers.
- Variable rates include both the fixed margin (determined during your loan assessment), and the variable base rate (changes during your loan tenure).
- At Prodigy Finance, we believe in transparency and disclose the interest rate split between fixed margin and variable base rate up front in the loan process. For our base rate we use the 3-month CME Term SOFR, determined by independent financial institutions and we have no influence on fluctuations.
- Assessing market fluctuations allows an understanding of the effects base rate changes have on your loan.
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