This post is the third in a series about student loans. I honestly don’t know what to write for an intro because all I want to say is “STUDENT LOANS AHHHHHHHH!” Can we get these things out of our lives already? Anyone with student loans has at least one of three goals: reducing monthly payments, reducing the lifetime interest expense, or paying off the loan as soon as possible. Refinancing may actually help you accomplish all three.
What is Student Loan Refinancing?
Refinancing is taking out a loan to pay off another. The most common reason for refinancing is to reduce your interest rate. When it comes to student loans, there’s a lot of opportunity to refinance into a lower rate.
Private lenders offer different rates to students and graduates. Students are considered high risk because there’s uncertainty around them finding a job to pay off their loans. Borrowers who have graduated and are employed on the other hand, are considered less risky. Since there is more certainty that they can make payments, lenders can charge a lower rate. This creates an opportunity to refinance existing federal or private loans into a new private loan at a lower rate. However, just because you can refinance into a lower rate loan doesn’t mean you should.
As mentioned in the first two posts of the series, Understanding Your Student Loans and Student Loan Repayment Plans, federal student loans offer unique protections and benefits for borrowers. Many of these benefits may outweigh the savings from refinancing to a lower rate. In particular, income-based repayment, opportunities for forgiveness, and the option to defer monthly payments are huge benefits of federal loans.
Will You Use the Benefits of Federal Student Loans?
If you’re looking to refinance your federal student loans with a private company for a lower interest rate, first find out if you could be taking advantage of the benefits of federal loans.
Income-Based Repayment Plans – If your required monthly payment is deemed too burdensome for your level of income, you may benefit from an income-based repayment (IBR) plan. Additionally, IBR plans can lead to loan forgiveness after 25 years. If you have any chance in benefiting from this, you’d be foolish to refinance into private loans.
So how do you know if you’ll benefit? The easiest way is to use the repayment estimator detailed in the repayment plan post mentioned above. It will calculate if you could reduce your current payments by enrolling in one of the IBR plans.
Opportunities for Forgiveness – This is without a doubt an amazing and unique benefit of federal loans. The balance of your loans could be forgiven as part of an IBR plan, as mentioned above, or through public service loan forgiveness. This program allows borrowers that are employed by the government or a non-profit to have their loans forgiven after ten years of on-time payments. To find out if your position qualifies for this type of forgiveness you can submit a certification form.
Deferment – This benefit of federal loans allows you to stop making loan payments for a period of time due to financial hardship. If you believe there is a low chance of losing your job or another steady income source, you may never need to defer your payments.
If you don’t believe that you’ll be taking advantage of any of these benefit to federal loans, you should explore the opportunity to refinance for a reduced rate.
Consolidation is Not the Same as Refinancing
A common misconception is that consolidation allows you to refinance federal loans into a new, lower rate federal loan. However, these two actions are not the same. Refinancing can only be done through a private lender. Consolidation simply combines multiple loans into one balance, monthly payment, and interest rate. The major difference is that the overall interest rate does not change in consolidation. The rate on the new loan is equal to the weighted average of all the components.
Consolidating federal loans has two advantages: simplicity and access to benefits. If you have multiple loans, required payments, and servicers, consolidation can help you simplify under one loan. It may also allow you to access IBR plans that are unavailable for certain types of unconsolidated loans.
Consolidation can be great, but it’s not the right choice for everyone. If you have multiple loans and are making monthly payments beyond the required amount (or plan to in the future), you should strategically make those payments on the loans with the highest interest rate. This would pay off the costliest loans first and reduce your lifetime interest expense. However, if you consolidate your loans, you cannot choose to pay off the high rate loans first. Each additional monthly payment will in effect be spilt equally between all of the component loans.
How to Refinance Your Student Loans
There are a lot of different private lenders that will refinance your student loans. Student Loan Hero has done the research for us and provides a list of their top six lenders. When comparing your options, there are three main factors you should consider: the interest rate, length of the loan, and the terms.
Interest Rate
In general, you’re looking for the lowest rate available. Lenders will base your rate off your income, credit score, and loan balance. (Check out the post How to Get a Higher Credit Score for tips on improving your score before refinancing.) You’ll likely receive two different types of interest rate quotes from private lenders: variable and fixed. (All federal loans are fixed.)
So which is right for you? A fixed loan maintains the same interest rate for the entire length of the loan. The rate on a variable loan, in contrast, adjusted periodically (e.g. daily, monthly, annually). Currently, interest rates are at historic lows, which is good for borrowers. However, this means they may go up in the future as they revert back to the mean. That being said, the choice between fixed and variable comes down to personal preference because the future of interest rates is difficult to predict. Variable rates are generally lower than fixed rates. Which means you could save money by choosing a variable loan. However, the risk with choosing a variable rate loan comes if interest rates rise. This would cause the monthly payment on the variable loan to increase, while the fixed rate loan payment would remain constant.
Your preference will be based somewhat on your risk tolerance, but should also be influenced by your intention with the loan. If you are refinancing into a relatively short-term loan (5 years), variable may make sense because rates are at historic lows and there is less time for a dramatic increase. On the other hand, fixed may be best for long-term loans (15-20 years) because you’ll have certainty in your interest rate.
Length of the Loan
The basic repayment plan for federal student loans has a length of ten years, whereas extended repayment plans last 25 years, and income-based repayment plans last 20-25 years. If you refinance into a private loan, you have more options for length. Generally, private student loans have terms of 5, 7, 10, 15, or 20 years. It is important to consider length because it has a significant impact on your required monthly payment and the lifetime interest expense you’ll pay.
If you can afford to increase your monthly payment, consider reducing the length of your loan when you refinance. This will reduce your lifetime interest expense and you’ll rid yourself of student loans faster. If you are refinancing to receive relief from a required monthly payment that’s too burdensome, the reduced interest rate may provide sufficient relief. If it doesn’t, you can consider increasing the length of your loan, but be aware that it will increase the lifetime interest expense you pay as well.
The Terms
Just because a private lender offers the lowest rate for refinancing doesn’t make them the right choice. Some lenders offer important benefits such as deferment or other hardship programs similar to federal loans. For example, the private lender SoFi offers career support and will even help you negotiate your salary (because it will help you pay off your loan).
Another benefit you should pay close attention to is the ability to make additional or early loan payments without penalty. Some lenders will charge a fee for paying off loans sooner than scheduled. Avoid these lenders! It’s important to retain the flexibility to pay your loans off early if your cash flows allow it.
As with most financial decisions, determining which loan terms are important is a personal choice. Recognize that there are differences between private loan providers and decide which loan is best for you.
How Much Will You Save By Refinancing?
It’s often not immediately clear if refinancing is worth the time or cost savings. This is especially true if you’re uncertain as to whether you’ll take advantage of any of the federal loan benefits. Luckily, the internet offers many different calculators (such as SoFi’s) to help you make the decision. Plug in your current loan details alongside the quotes from lenders, and you’ll see how your monthly payment and lifetime interest expense will change.
Conclusion
Refinancing your student loans could help you reduce your monthly payment, pay off your loans faster, or reduce your interest expense. If you have federal loans, refinancing is not a decision to be taken lightly. Although there are generally cost savings, you may be forfeiting considerable benefits such as income-based repayment, opportunities for forgiveness, and the ability to defer payments. Don’t let a lower interest rate entice you into making a decision that cannot be reversed.
Interested in one-on-one advice to take control of your student loans? Click here to schedule a FREE 30 minute call with David, a Certified Financial Planner (CFP®) professional and Certified Public Accountant (CPA), and get answers to all of your money questions.
