Millions of students are discovering the hard way that when they take on large amounts of student debt in order to pay the high costs of a college education, it can be next to impossible to get their loan balances paid off. One big part of the problem is that on top of having to pay back what they borrowed -- which often amounts to tens of thousands or even hundreds of thousands of dollars -- student borrowers have to pay interest on their loans. Interest makes the monthly payments on student loans even higher than they’d otherwise be, especially when the interest rates on a loan are higher; it can add thousands of extra dollars to what a student borrower ends up having to pay.
Student borrowers who are struggling to repay their student loans often look for ways to make their obligations easier to handle, and refinancing loans can in some cases be a smart way to reduce the amount of interest you’ll have to pay. However, refinancing isn’t always a good option, as it depends on what kinds of student loans you already have and their particular terms. If you just move forward to refinance your student loans without looking at the specifics of your loan portfolio, then it could actually end up costing you. Below, we’ll look at how to tell whether refinancing will benefit you, and also give you an idea of just how much you might be able to save.
What refinancing means, and why it can (but won’t always) save you money
Refinancing involves taking some or all of your existing student debt and getting a new loan with different terms to replace it. This differs slightly from student loan consolidation, in which multiple student loans get combined into a single loan. The primary difference is that with refinancing, the student will have to go through a brand new credit approval process in order to get the new loan. By contrast, with consolidation loans -- especially federal consolidation loans -- there’s typically a process in place to allow lenders to grant the consolidation loan without the same extent of credit checking.
To refinance your student loans, you’ll need to work with a private lending institution. The lender will look at the total amount of debt that you’re looking to refinance and then go through its ordinary credit process to come up with proposed terms of the refinancing loan. Some of the features that a refinancing loan can offer include the following:
- A lower interest rate. Depending on the interest rates on the student loans that you currently have, you might be able to qualify for a loan with lower rates. This will be based on things like your credit history, the amount of debt you’re looking to refinance, other debt you have, and your income and other financial resources that will determine how you’re able to repay the loan.
- Lower monthly payments. Lower interest rates are one way to make your monthly payments smaller than they are on existing student loans, but there are other ways lenders can change the amount you’ll pay each month. The easiest way for a lender to get a reduced monthly payment is to extend the length of time you’ll have to repay the loans.
- Simpler financial management. If you have multiple outstanding student loans, it can be cumbersome to handle making several different payments month after month, sometimes to different lenders. If you elect to refinance several loans into a single refinancing loan, then you’ll only need to make a single monthly payment.
All of those features can be attractive, but not all of them will save you money. The real key to successfully saving money through refinancing is getting lower interest rates. If you only focus on monthly payments instead, then it can be easy to ignore the fact that changing other terms in the original loans -- most notably, the repayment period -- can end up costing you more rather than less in the long run.
A simple example of a smart refinancing
To give you an idea of just how much refinancing a student loan can save you, consider a scenario that’s unfortunately all too common among student borrowers. Say that you didn’t qualify for federal student loans when you were in school and you used up all your financial resources in the first three years of school. For your fourth year, you had to borrow $60,000 to cover all of your costs, with a 10-year term at 9% interest. As a result, when you calculate your student loan payment, you’ll owe a monthly payment of $760. Over the lifetime of the loan, you’ll pay more than $31,000 in interest on top of the $60,000 in principal.
Now say that you find out that you’ve gotten a good job right after you graduate. When you do some research, you find a different lender willing to refinance that loan with the same 10-year term but at 6% interest. When you run the numbers, you’ll see that the monthly payment will go down to $666, saving you $94 each month. In all, you’ll pay less than $20,000 in interest on the loan over the course of the next 10 years -- a savings of more than $11,000. In this case, refinancing makes sense as long as the total amount of any refinancing fees the new lender charges is less than the $11,000 in interest savings.
How refinancing can actually cost you
Unfortunately, not all refinancing scenarios work out this well. Private lenders want to make profits, and so their interests won’t always align with yours. If you focus on the wrong things, then you can end up paying more.
As an example, take the scenario above but make a simple change. Instead of offering you a lower-rate loan for the same term, the private lender instead offers you the same $60,000 at the same 9% interest rate but gives you a term of 15 years to pay it off.
At first glance, the resulting terms might look even more compelling. Your monthly payment will fall all the way to $609 -- another $57 below what you’d pay in the first example above. For a cash-strapped student borrower, getting monthly payments down can seem like the most important thing.
However, in exchange for the lower payment, you’re taking on the burden of five extra years of monthly payments. In total, you’ll end up paying more than $49,500 in interest over the course of the 15-year refinancing loan. That’s $18,500 more than you would have paid with your original student loan.
Other things to watch out for with refinancing
The scenario above involved a borrower who only had high-rate private student loans, which is the situation in which refinancing will most often make sense. In other scenarios, it’ll be harder to find favorable refinancing terms. Consider the following:
- If you have federal student loans, interest rates are usually lower than you’ll find from most private lenders. In order to offer a lower monthly payment, a private lender will almost always have to lengthen the repayment period -- costing you more in interest.
- Some federal student loans have extra benefits like loan deferment, forbearance, or even forgiveness under certain situations. Refinancing those loans almost always forces you to give up those extra benefits. Even if there is legitimate interest savings, losing student loan forgiveness can offset that savings and end up costing you.
What this all comes down to is that it’s critical to weigh all the advantages and disadvantages of refinancing compared to what your existing loans offer. Even if a refinancing loan offers a lower monthly payment, it won’t always save you in the long run. A refinancing loan will only truly produce lasting savings if it either gives you a lower rate or shortens the period over which you’ll repay the loan.