By Jacob @DollarDiligence Follow Him on Twitter for More Posts About Killing Student Debt!
Did you know that 44 million Americans now have student loan debt? It’s the big reason why student loan refinancing has become a burgeoning industry. Many of the major banks have offered student loan refinancing for a while, but the real growth in the industry is coming from new players.
Non-traditional, online-only financing companies such as SoFi, LendKey, Earnest and CommonBond are beginning to dominate the market. For many student borrowers, these companies offer the only relief from suffocating loan payments. But, although refinancing should result in lower payments, there could be a heavy price to pay.
How Does Refinancing Work?
When you refinance a student loan, you are essentially taking out a new loan. Many students have multiple loans, so, if a lender can lower the average loan rate, it will consolidate both private and federal student loans into one new loan. The lender uses the proceeds of the loan to pay off existing lenders and becomes the new loan servicer.
As with any private loan, the borrower must be able to qualify for the loan based on credit requirements. Many student borrowers don’t have the credit standing to qualify for a loan or a low rate, so they can enlist a co-signer – typically a parent or relative – who does have good credit.
The loan is issued with a new term of 5 to 25 years. Until recently, most student loans were issued with variable rates. Many of the newer entrants into the market, along with some banks, now offer fixed-rate loans. The initial rate on a variable loan is typically lower than a fixed-rate loan, but it can be adjusted upward by the lender when market interest rates increase. Most loans are issued with no origination fees.
How Much Can You Really Save by Refinancing?
Generally, it might not make sense to refinance your student loans unless you can obtain a rate 1 to 2 points below your existing rates. Keeping in mind that only the most creditworthy borrowers can qualify for the lowest rates, that may be difficult to do.
Say you have four student loans with a remaining balance of $20,000 and an average loan rate of 6%. Based on your original balance of $25,000, your monthly payment is $190 (after deferring your loans for six months after you graduated) for a 20-year term.
If you are able to qualify for the lowest fixed rate from SoFi, currently 3.35%, you could lower your monthly payment to $114 a month with a new 20-year term. Or, if you wanted to pay your loan off more quickly, you could shorten the term to 10 years and pay roughly the amount, $196 a month.
You could lower your monthly payment even further by choosing a variable-rate loan. SoFi’s lowest variable rate is 2.80%, which would reduce your monthly payment to $108 a month. However, the extra $6 in monthly savings probably isn’t worth the risk of interest rates rising, which could result in paying more than your current monthly payment.
You won’t know the actual rate on your loan until you apply. If you are offered a rate that won’t significantly lower your monthly payment, you should consider whether it is worth the cost of losing some important protections on your federal loans.
Related blog post: 3 Reasons to Refinance Your Student Loans
What are the Reasons I Should Not Refinance?
For many borrowers, lowering their monthly payment or total interest costs is a good reason to refinance their student loans. However, when refinancing federal student loans, there are three big caveats to consider.
First, you lose key protections provided by the federal government, including the options of forbearance and deferment, which are available when you experience a severe financial hardship. Most traditional lenders offer neither option, while some of the newer on line lenders do.
Second, you lose the option of switching to an income-based repayment plan, which is available when your income isn’t enough to cover the loan payment. These repayment plans may extend your loan term while lowering your monthly payment. They also provide for loan forgiveness after 20 years of on time payments.
Finally, if you are in or plan to go into public service work, such as non-profit medical services, education, public safety or law enforcement, you would lose your eligibility for loan forgiveness after 10 years of on time payments.
Refinancing may be a good option if you know for certain you won’t have any need for these protections and you have the financial capacity to pay down your debt quickly. Otherwise, the price for a few dollars of monthly savings could be really high.
Be sure to consider your options and do your research before making any decisions.
Jacob runs his own personal finance blog over at Dollar Diligence. Through meticulously watching his money and extreme frugality, he was able to pay down over $25k in student loan debt in just 15 months. You can learn more about his story and follow him here.