Student loan debt remains a huge financial burden for millions of Americans.
More than six in ten (62%) Americans who graduated college in 2019 have student loan debt and owe an average of $28,950, according to an October 2020 report released by The Institute for College Access and Success, a nonprofit group.
It’s not all bad news: Federal student loan interest rates have dipped below 3% — and some private student loan rates are even lower. This could make refinancing student loans an attractive option for many.
But it’s not as straightforward as it seems.
The best interest rates are available only to borrowers with strong credit profiles and high incomes. And depending on the type of student loans you have, refinancing could be a bad move.
Right now, all payments, interest, and collections have been suspended for government-held federal student loans. The forbearance and interest freeze for federally held student loans is currently scheduled to end on Dec. 31, 2020. So until then, there’s little reason to consider refinancing those types of loans. “You’re never going to beat a 0% interest rate, so certainly for the time being at least, there’s no reason to [refinance federally held student loans],” Adam S. Minsky Esq., who is an attorney specializing in student loans.
When Student Loan Refinancing Doesn’t Make Sense
“I’m very cautious about recommending that folks refinance any federal loans to a private loan because of what you’re giving up,” Minsky says.
There are a number of benefits and protections federal student loans may qualify for: death or disability discharge, default resolution, and deferment or forbearance options. Federal student loans can be eligible for repayment plans based on your income and loan forgiveness if you make qualifying monthly payments while working full-time for an eligible employer.
That’s a lot to give up — and going that route would make sense only if you can drastically reduce your interest rate or pay off the loans quickly. Even then, Minsky recommends mitigating some of the risk by having a fully funded emergency fund and adequate life and disability insurance.
Instead of refinancing federal student loans, you can take advantage of the federal student loan consolidation program. When you consolidate federal loans you retain all the benefits, but the interest rate is a weighted average of the previous loans. It won’t reduce your interest rate, says Mark Kantrowitz, vice president of research at savingforcollege.com, but it does have other benefits.
When you consolidate, all of your loans are folded into a single, easy-to-manage payment. You may also be able to extend your repayment term with a consolidation and lower your monthly payment. Keep in mind, just like with a private loan refinance, when you extend your loan you’ll increase the amount of interest you’ll pay over the long haul.
When to Refinance Student Loans
If you have a private student loan, refinancing usually makes sense when you can save on interest over the long haul or lower your monthly payments.
Cutting your interest rate by just one percentage point on a $37,000, 10-year loan could save you roughly $18 a month and $2,200 in interest over the life of the loan. And you have the potential to save much more if you’re refinancing higher-interest debt, like graduate school student loans. Even if you can’t qualify for a lower interest rate, refinancing that same loan into a 15-year term would save you about $100 per month.
Unlike other types of loans, student loan refinances generally don’t come with upfront origination fees.
But a word of warning: Whenever you extend a loan’s term you’ll end up paying more interest over the life of the loan. For the example above, you’d pay over $5,500 more in interest by adding five years to the loan term.
Since it’s easy to refinance student loans without paying upfront origination fees, there are a lot of other situations where it makes sense. You can refinance to convert an adjustable interest rate into a fixed-rate loan. Refinancing is also one way for a borrower to drop a co-signer from the loan.
Mary Hobbs, founder of the personal finance site Pennies Not Perfection, was able to refinance her mother’s federal parent PLUS loans and transfer them to her name. “I didn’t want my mom, specifically, to end up on a fixed income with this huge pile of student loans. So I decided since I could pay them off I would,” Hobbs says. By refinancing those loans to her name, Hobbs was able to drop the interest rate from 8.5% to a 2.57% variable rate. Hobbs plans to pay the loan off in two to three years — so the lower variable rate allows her to pay off the loans a bit more quickly.
How to Refinance Student Loans
Refinancing student loans has a big advantage over other types of debt, like mortgages, because upfront loan origination fees are very rare.
Since most lenders don’t charge student loan refinancing fees, comparing offers is simple. It’s a matter of finding the lowest interest rate or the ideal loan term.
Completing a refinance application is fairly straightforward, but you’ll need to include supporting documents to verify your income and identity. And to qualify for a refinance you’ll need healthy credit scores (typically 650+) and usually a debt-to-income ratio (DTI) of 50% or less — although these numbers will vary by lender. As your financial profile improves, a lower DTI and higher credit score can help you qualify for lower interest rates.
“It’s not just your credit scores that affect your eligibility for a private loan. They’re also going to look at information that isn’t in your credit history,” says Kantrowitz. Lenders will want to know your income and how long you’ve been at your current job. “Generally speaking, the lender is going to want to see that you’ve been at the same employer for at least two years,” he says.
This can be a dilemma for new graduates without a strong credit history or high income.
Samantha Sands, 22, of San Diego, California graduated with $120,000 in private student loans with interest rates varying from 7% to 10.5% and found it difficult to find a lender willing to refinance her debt. “It’s been quite a nightmare,” Sands says. She says she didn’t make enough money to qualify for a refinance and had to add her mother as a co-signer. Even then, she was unable to qualify for a lower interest rate. She did manage to reduce her monthly payment by $600 by refinancing to a longer, 15-year loan term.
If you need a co-signer to refinance your student loans — or get a better interest rate — it’s important for the co-signer to understand the commitment. “The co-signer is fully legally responsible for the entire loan just as much as the borrower,” Minsky says. “If the borrower stops paying, the co-borrower is on the hook.”
Refinancing student loans can be a bit of a catch-22. You’re more likely to qualify for a lower rate if you have a high income and credit score. But the borrowers who are most in need of the financial relief a student loan refinance can provide are the least likely to qualify for a good deal. However, because you can refinance student loans without paying upfront fees, even small financial gains can make refinancing a worthwhile move. Just be sure you aren’t giving up the valuable protections that come with federal loans without serious consideration.