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Why Refinancing Your Federal Student Loans Could Cost You

People with federal student loan debt now have a few options to lower their rates with private consolidation loans, but consumer advocates warn they could be giving up vital protections in doing so.

Royal Bank of Scotland Group Plc's Citizens Financial Group recently expanded its student loan refinancing program to include federal as well as private student loans. The bank joins two much smaller, peer-to-peer lenders, SoFi and CommonBond.

All three lenders say they counsel potential customers about the consumer protections lost when federal debt is refinanced into private loans. Those protections include access to federal income-based repayment and forgiveness programs as well as generous forbearance and deferral options.

"Those are very important rights," says Persis Yu, staff attorney for the Student Loan Borrowers Assistance site run by the National Consumer Law Center.

Yu questions whether the borrowers targeted by these lenders understand how vulnerable they are to financial setbacks such as job losses.

"A lot of people think they're not ever going to default," Yu says, "but there are very high delinquency rates on student loans."

Who's getting loans

So far the lenders are wooing the lowest-risk borrowers: graduates with steady jobs, good credit and enough income to pay down their loans.

CommonBond, which has refinanced about $100 million in student loans so far, restricts its prospective clients even further to those with business, law, medical, or engineering degrees, says Chief Executive Officer David Klein.

The lenders tout variable rates that start at less than 3%. Fixed rates can be as low as 3.6% at SoFi and Common Bond, while Citizens' lowest is 4.74%.

By contrast, current interest rates for new fixed-rate federal Stafford loans are 4.66% for undergraduates and 6.21% for graduate and professional students. Borrowers with older federal debt may have rates as high as 8.5%.

While the best rates on consolidation loans are reserved for the most creditworthy borrowers, Citizens has been able to lower its typical customer's rate by 1.5 percentage points when refinancing private loans, says Brendan Coughlin, the company's president of auto and education lending.

A one-percentage-point decrease corresponds to annual savings of about $50 per year on each $10,000 of debt, says Mark Kantrowitz, publisher of Edvisors.com, a college finance education site. The savings generally are not enough to make it worth giving up income-based repayment and forgiveness options, he says.

Borrowers who struggle to pay their debt are typically locked out of refinancing due to lenders' high underwriting standards.

"We're approached by people who are having a really difficult time with their payments," says Mike Cagney, CEO of SoFi, which so far has refinanced about $1 billion in federal and private loan debt. "We're not a good option for them."

Parents may benefit

Parents who have federal PLUS loans, however, might consider refinancing into a private loan if they can win a large-enough interest rate reduction, Kantrowitz says.

Parent PLUS loans are not eligible for income-based repayment options or forgiveness, although they still offer up to three years of forbearance and deferral options. Private consolidation loans typically offer up to one year of forbearance.

"Generally, refinancing federal parent PLUS loans into a private consolidation loan might be financially beneficial if the interest rate will decrease by at least two percentage points and the borrower has at least $20,000 in [such] loans," Kantrowitz says.

"Students, on the other hand, should still not refinance their federal student loans into a private consolidation loan."

Parents with the high credit scores and solid incomes necessary for a private loan consolidation presumably would be able to make informed decisions about the necessary trade-offs between a lower interest rate and the loss of federal education loan benefits, Kantrowitz says.

A proposal to lower rates on existing federal student loan debt died this summer when Senator Elizabeth Warren, a Massachusetts Democrat, failed to get the 60 votes needed to advance her bill. The legislation, which would have allowed people with federal and private loans issued before 2010 to refinance at 3.86 percent, received 56 votes for and 38 votes against it.

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