College is expensive, and it's hard for most families to foot the cost without help. Even when I was in college 30 years ago, it was common for kids and their parents to get student loans to help bridge the gap between tuition costs and what schools offered in grants and scholarships.
Now the problem's even more extensive, with tens of millions of students having to borrow. They put themselves at a major financial disadvantage at the beginning of their careers.
Once you're out of school, you'll start repaying your student loans -- and the interest rates might be high. But, in some cases, you can refinance your student loans and save yourself a boatload in interest charges.
Because there are some traps for the unwary student loan borrower, it's important to understand the ramifications and tradeoffs of refinancing your loans. We'll tell you below what you need to know.
Refinancing and consolidation aren't the same
Many people confuse refinancing and consolidation. The two concepts have a lot in common, and it can seem like they’re interchangeable. Both allow you to combine multiple loans into a single loan. And both let you change some of the terms of the original loans to make repaying them more convenient.
Consolidation is taking two or more loans and merging them into one. The way that's done depends on the type of student loan involved. A federal Direct Consolidation Loan combines multiple federal student loans into a single consolidated loan. That lets you make a single payment.
But federal consolidation doesn't allow you to lower the interest rate on your student loans. The government calculates the consolidation loan’s interest rate by taking the weighted average of the loans you're consolidating. Let’s say you have two loans of the same amount with interest rates of 3.75% and 4.25%. Your consolidation loan would have an interest rate of 4%. That’s the average of the two loans. That won't produce any interest savings at all.
Refinancing is different. It involves taking out a new loan to pay off one or more student loans. If the rates you can get by refinancing are less than what you're paying currently, you'll save money. If rates are higher, it'll be more costly and you won't have any incentive to refinance.
If you can save money on two or more loans through refinancing, you'll have the option to combine them into a single loan or keep them separate.
What to watch out for with refinancing
Refinancing comes with a big red flag: You can't refinance a federal student loan directly with the federal government. You have to go to a private lender, and that has major consequences.
The biggest problem with refinancing federal loans is that you lose their special benefits. You won't have the option of choosing federal income-driven repayment options with more affordable payment terms. You won't be eligible for federal loan forgiveness programs. And you'll often lose the ability to defer loan payments or get forbearance in certain situations.
There are also some other things to keep in mind.
First, lenders don’t always focus on helping you reduce interest costs when you refinance. Instead, they focus on reducing the size of your monthly payments.
That’s attractive, but private lenders can raise the interest rate on your loans to give you a smaller monthly payment. That most often happens when you refinance federal student loans with a private lender. In doing so, you exchange a low interest rate for lower monthly payments. But that creates a longer repayment term. And that means you pay more interest over the course of the refinanced loan.
Second, private lenders can offer lower rates by switching your loan from a fixed-rate loan to a variable-rate loan.
At the offset, your interest rate on a variable-rate loan can be lower than what you'd pay with a similar fixed loan. But if prevailing interest rates rise, your monthly payments can rise as well. Of course, falling rates can make variable-rate loans even more attractive -- but 2019 interest rates are already low. The risk of paying more exceeds the potential to produce even more savings.
The unusual way I saved big money refinancing my student loans
Most people go to financial institutions for student loan refinancing. These knowledgeable professionals can answer questions and tailor your refinanced loan to your needs.
But I found myself in an unusual and fortunate situation. I had $18,500 in private student loans from law school. At the time, they carried a high interest rate of 9%. I'd gotten a good job and wanted to pay off these higher-interest loans as quickly as possible.
I found a 0% credit card balance transfer offer that let me refinance my student loan debt for 18 months. This card didn’t have the typical fee of 2–4% for balance transfers -- just a fixed charge of $25. Because I'd worked between college and law school, I'd built up a good credit history. I was able to get a credit limit to cover the full $18,500.
By paying just over $1,000 a month for the 18 months of the 0% offer, I repaid that private loan in full. That saved me $1,346 in interest. Now I only have the more favorable low-rate federal loans to repay.
Be smart about refinancing
Saving money by refinancing your student loans is all about cutting the interest rate.
Don't get trapped by financial institutions offering you rock-bottom monthly payments. They often come with longer repayment periods that eat up any interest savings. Instead, find low-rate loans by any means necessary. Especially when it comes to replacing high-interest private student loans that already have unfavorable terms.