Homeowners are constantly told to refinance their mortgages to lock in lower interest rates. But there's less buzz about refinancing when it comes to another significant source of debt: student loans.
You can in fact refinance your student loans, but there are some pitfalls that make the process tricky. Let's go over four things you need to know before getting started.
1. Refinancing is different from consolidation
When it comes to student loans, the terms "refinancing" and "consolidation" are lobbed around interchangeably. But they're different processes with different goals.
Consolidation happens when you combine several federal student loans into one federal consolidation loan with a fixed interest rate. Essentially, this becomes a "megaloan" with one payment and one due date. Consolidating can help you stay organized -- after all, one payment is easier to keep track of than four or five -- and you get to retain most federal student loan benefits (more on those in a minute). However, consolidation is not typically a money-saver: Your consolidation loan's interest rate will be the weighted average of your old loans' rates.
So how do you actually save money? That's where refinancing comes in. Refinancing is offered only through private lenders. Both federal and private student loans are fair game. Again, you'll be taking out a new loan to pay off your old ones, and that can help you stay organized. With refinancing, though, you're probably looking for some tangible savings in the form of a lower interest rate. The catch? These low rates are reserved for borrowers with top-notch credit, whereas credit isn't a factor in federal student loan consolidation.
2. Refinancing may mean your federal loan benefits evaporate
Refinancing with a private lender might save you money, but federal student loans come with important borrower protections that won't stick around once you move your debt. They include:
- Flexible repayment options, such as income-driven repayment plans that adjust your monthly bill according to your discretionary income.
- Deferment, which allows you to delay repayment in several circumstances, such as unemployment, economic hardship, and active-duty military service. If you had Perkins or subsidized Loans, then Uncle Sam also pays the interest that accrues on your loans during deferment.
- Forbearance, which is similar to deferment but a bit easier to obtain. The crucial difference is that you're always responsible for the interest.
- Discharge of loans upon permanent disability or death.
- Public Service Loan Forgiveness, which forgives the remaining balance of your loans after 10 years of qualifying repayments if you work for certain public-service employers.
Some private lenders also offer benefits, but they're more limited in range and scope. For instance, private lenders that offer deferment will almost always require borrowers to continue paying interest.
3. Lenders set the bar high to qualify for low interest rates
Lenders' decisions on whether you qualify for refinancing -- and the interest rate you'll pay -- mostly boil down to whether you have a good credit score and a steady, well-paying job. Unfortunately, that means those who could benefit most are often passed over in favor of those who can easily afford their current payments.
You may be able to qualify for a low-rate loan with a co-signer, typically a parent or relative with great credit who agrees to be responsible for the loan in case you default. This isn't a decision to make lightly: Your co-signer will still be on the hook for repayment even if you die. That kind of responsibility can strain a relationship and should probably be your last resort.
4. Lower rates may have strings attached
If you're able to qualify for student loan refinancing, double-check that you'll save money in the long run. Lower monthly payments don't always mean overall savings.
For example, let's say you have a $10,000 loan with a 6.8% interest rate. Over a 10-year repayment term, you would pay about $115 a month for a total of about $13,810 over the life of the loan. A lender might offer you a lower interest rate, say 4.5%, and tell you that he or she can cut your payment almost in half, to $63 a month. But you've doubled your repayment term to 20 years, and therefore you'll pay about $15,184 over the life of the loan.
That temptingly low interest rate also might be variable, while federal student loan rates are fixed. Though the fixed rates might be slightly higher, you know what you'll be paying year after year. Variable rates, on the other hand, may start low and creep higher -- a risk that increases as the economy improves and the Federal Reserve considers raising the federal funds rate.
In the end, is refinancing those student loans worth it? For borrowers with solid finances who simply want more budgetary breathing room, it can be a no-brainer. But if you're on shakier ground, even if you qualify, proceed with caution: Uncle Sam's income-based repayment plans and other benefits are probably worth holding on to.