If you have student loans whose monthly payments eat up an uncomfortable chunk of your income, you may be motivated to refinance that debt. Refinancing is the process of swapping one loan for another. You can do it with all types of debt -- not just student loans. However, the upside of refinancing student debt is that you can generally do so at no cost (whereas, for example, if you refinance a mortgage, there are closing costs involved).
Refinancing your student loans makes sense when you're convinced you can snag a lower interest rate on that debt than the one you're currently stuck with. Generally speaking, refinancing works better in the realm of private student loans than with federal loans. That's because federal loans are regulated by the government, and their interest rates are capped at a reasonable level. By contrast, private lenders can charge what they want, so often there's savings to be reaped by refinancing.
However, no matter what type of student loans you currently have, there are a few key moves you should make before refinancing them. Here are three steps it especially pays to check off your list.
1. Improve your credit score
The whole point of refinancing your student debt is to score a lower interest rate on those loans. That way, your monthly payments will be reduced in the process. But one factor lenders take into account when determining what rate you're eligible for under a refinance is your credit score. So if yours isn't great, it pays to boost your score before going through the refinancing process.
The best way to improve your credit score is to pay all of your incoming bills on time to boost your payment history. However, that takes time. If you're looking for a quicker fix, paying off a chunk of your revolving debt (aka your credit cards) could do the trick.
Credit utilization is a big factor that goes into determining your credit score, and getting it below 30% is a big help to your score. If your total line of credit is $5,000 and you have $2,000 in outstanding debt, you're at 40% utilization, which isn't great. But if you pay off $500 of that debt, you'll knock your utilization down to 30%, at which point you'll likely see your score improve.
2. Get a steady job
Your chances of getting approved for a student loan refinance are higher when you can prove that you have a reliable source of income. That's why securing a steady paycheck is important -- it will give lenders confidence that you'll be able to keep up with your monthly payments under your new loan.
Another thing you should know is that the higher your income, the more likely you are to get approved for a refinance. That's because lenders take your debt-to-income ratio into account when determining your eligibility, and that measures your outstanding debt obligations relative to your income. The lower that ratio is, the better. So if you're able to boost your income by finding steady work, you'll be helping your own cause.
3. Make sure you're not giving up favorable loan terms
As mentioned earlier, it is possible to refinance federal student loans. And if your credit is great, you may qualify for a better interest rate on that debt than what you have now. But before you refinance your federal student debt, make sure you're willing to part with the borrower protections those loans offer, like income-driven repayment plans or the option to defer your payments for a period of time.
Remember, when you refinance your student loans, you don't just give up one interest rate for another -- you sign a completely new loan agreement with new provisions. As such, you'll need to really get on board with the idea of forgoing these and other built-in federal loan benefits.
Refinancing is often a good way to make your student debt more affordable. But before you do so, make sure your credit is solid, your income is stable, and your loan terms are worth giving up. The last thing you want to do is go through the motions of refinancing, only to get rejected because you're not a financially sound candidate ... or to get approved but regret your decision later on.