The first in a three-part series on refinancing student loans.
Part I: Should I Refinance My Student Loans?
Part II: Choosing a Student Loan Refinancer
Part III: Application Tips and Post-Refi
Those of us with student loans know what a mental hassle and financial drain they can be a, especially loans backed by the U.S. Department of Education, which can have interest rates as high as 7.9%. Fortunately there’s been an explosion of private institutions who offer “highly qualified” borrowers the option to refinance their student loans at lower interest rates. With the Federal Reserve likely to raise interest rates this week [Update: the Fed raised rates 0.25% March 15], we’re publishing this three-part series that will take you through the soup to nuts of student loan refinancing, starting with the threshold question of whether refinancing is right for you and your student loans.
We hear a lot of misconceptions about refinancing here at Y2C. Here are some of the most common, along with our responses.
- Refinancing My Loans Costs Money. Perhaps confused by the closing costs associated with refinancing a mortgage, some people think there are upfront fees associated with refinancing student loans. However, with student loans, there’s no appraisal fee or any other direct cost to refinancing (refinancing may temporarily impact your credit score and require you to forego certain federal loan benefits, both of which we discuss further down, but we have yet to see a refi provider that charges any fees to refinance student loans).
- I Plan on Paying off My Loans Quickly, so I Should Just Focus on that Instead of Refinancing. These two strategies are not contradictory, but complementary. If your goal is to pay down your loans as quickly as possible, then naturally you should want to pay as little interest as possible. Refinancing to a lower rate will allow a greater portion of your payments to go towards reducing the principal balance (i.e., the amount that your next interest payment is calculated off) instead of interest.
- To illustrate, imagine you have two loans: Loan F is your federal loan with a $100,000 principal balance and 7.65% annual interest rate over 10 years. Loan R is that same $100,000 loan refinanced to a 3.50% annual interest rate over 10 years. Your monthly payments on Loan F will be $1,194.86. Your monthly payments on Loan R will be $988.86. If you put that extra $206/month towards paying off Loan R, you’d pay it off in 8 years and 1 month, instead of 10 years, and save over $28,500 in interest. Feel free to plug your own numbers into our handy refinance/payoff calculator (note: you can only edit the 5 numbers in blue font)!
- You Can Only Refinance Student Loans Once and I’ve Already Refinanced. I’ve refinanced my student loans three times, each time to lock in a better interest rate. If you’re a qualified borrower with good credit, you have the luxury of shopping around for the best deal. Taking advantage of the best opportunity now won’t foreclose you from refinancing again later if the market changes.
- I Already Consolidated My Loans. Isn’t That the Same Thing? Consolidation merely combines all of your existing federal loans into one so that you can make a single payment. It doesn’t lower your interest rate (your new interest rate will be the weighted average of your previous loans), and it may actually cause you to lose some benefits. We do not recommend loan consolidation because it destroys your option to save money over the long-haul by paying off the highest interest rate loans first.
- If I Refinance One Loan, I Have to Refinance Them All. We have yet to find a refinance lender that won’t let you pick and choose which loans to refinance. Most lenders may have minimum principal amounts in order to refinance, but otherwise let you pick and choose which loans to refi.
- Everyone Should Refinance Their Student Loans. While refinancing can help some people save money on their student loan repayment, depending on your situation, it may not be right for you. We discuss some of the circumstances where you would not want to refinance your loans below.
Who Shouldn’t Refinance
While refinancing can offer big interest savings over the life of a loan, as noted above, it’s not for everyone. The major tradeoff with refinancing is that you’re foregoing certain federal loan protections (what we’ll call “Government Benefits“) in (partial) exchange for lower interest rates. Namely, Government Benefits are:
- Forbearance and Deferment– if you experience economic hardship, serve in the military, or return to school, you may be eligible for forbearance or deferment during which time you would not have to continue making loan payments. While some private refinancers offer forbearance-type benefits (e.g., Sofi offers a deferment, but interest continues to accrue; Earnest offers forbearance for economic hardship and discharge for total and permanent disability or death), these are typically less generous and mandatory than those offered by the federal government.
- Income-based Repayment Options– the Department of Education currently offers four different income-driven plans for federal loan borrowers. The hallmark of these plans is that you pay a certain percentage of your discretionary income, potentially over a longer repayment period. At the end of the repayment period, any outstanding principal is forgiven (though you may owe taxes on the forgiven amount).
- Loan Forgiveness– federal loans are eligible for a variety of forgiveness programs, including Public Service Loan Forgiveness, Teacher Loan Forgiveness, and Total and Permanent Disability discharge.
So with those Government Benefits in mind, here’s a look at circumstances where refinancing may not be the right choice for you.
- Government Benefits are Valuable. If you’re planning on a career in public interest and want an income-based repayment option, or you’re worried about losing your job with no forbearance options, the juice may not be worth the squeeze of foregoing Government Benefits. The public servant with limited income is the poster child for not refinancing. However, if you’re in the second camp (gainfully employed in the private sector, but worried about not being to pay off your loans long-term), make sure you take a look at our refinance calculator so you understand the cost of that insurance policy.
- By the way, if you only have private loans, this reason doesn’t apply to you!
- Your Interest Rates are Already Low. While graduate school loans can have interest rates around 7% or 8%, undergraduate loans are typically lower, possibly as low as 3.4%. If you have loans with rates this low, refinancing may not be a better deal (not to mention it will involve giving up Government Benefits).
- Refinancing May Jeopardize Other Non-Government Benefits. Even if you don’t derive any value from the Government Benefits, your educational program may offer other loan repayment benefits that might not survive refinancing. For example, Harvard Law School offers a Low Income Protection Program. Harvard’s LIPP is generally compatible with refinancing, but it requires that refinanced loans have a fixed interest rate and a repayment term of at least 10 years. If you think this caveat might apply, check with your alma mater before refinancing.
- You Won’t Qualify for Low Rates. Unlike the Department of Education, which guarantees all borrowers the same interest rate, private refinancers are able to offer lower interest rates because they only serve the least risky slice of the student loan market. Accordingly, refinancers will evaluate your credit, income, employment history, assets, and educational background. If your application isn’t excellent across the board, you may not qualify for the most competitive interest rates. That said, every refinancer has a slightly different formula and emphasis, so I wouldn’t let this stop you from applying around if your application is weak in one area, but strong in the others.
- You’re not a U.S. Citizen or Legal Permanent Resident. This isn’t a statement on immigration policy, just an acknowledgement that refinances will only lend to U.S. citizens and LPRs.
If you’ve read through this last and none of the foregoing categories have struck a chord, or if you’re thinking to yourself that you make a good salary in the private sector and are confident in your continued employment prospects, then congratulations, refinancing your loans may be a great way to save some money!!
Student loan refinance isn’t for everyone. If you derive value from the Government Benefits or fall into any of the other categories previously mentioned, then there’s probably no point in refinancing your student loans. However, if you have a steady income with no anticipation of shifting to a lower-paying career track and you’re tired of paying usurious government interest rates, then you should probably lock in lower interest rates while you can before the Fed raises them. In the second part of this three-part series, we’ll review the best refi providers out there, complete with pros, cons, and referral links.