The ads are everywhere. If you have student loans, you know the ones I am talking about. They urge you to Refinance Now! and Get a Better Rate! and Save a Ton of Money!
Don’t be duped. There are some serious flaws in refinancing your student loans. Some websites generate revenue by advertising refinancing options and they may not have your best interests at heart. Avoid these refinancing mistakes by understanding how the process works for your specific situation.
Three Considerations When Refinancing Your Student Loans
A common claim is that consolidating your student loans will simplify repayment and reduce your monthly payments. Simplifying repayment does not necessarily mean that it is the best choice for you. There are three things to look at when determining if refinancing is really worthwhile.
- Size of the Payment. This is the amount you will pay each month towards your student loans. Your payments are first applied to the interest and fees on the loans, then to the principal (the amount you borrowed). A lower payment means less money is being paid to principal, slowing your progress in repaying the debt. Thus, a lower payment is not always a good thing as it can extend the length of your loan and increase the total amount of interest paid.
- Length of the Loan. This is how long you will be paying off the student loans. When refinancing, a common pitfalls is that the length of the loan is extended in order to obtain a lower payment. This means your 10 year pay off could turn into a 30 year payoff. Do you really want to be in debt for most of your work life? A longer loan also means paying more in interest over the term of the loan.
- Interest Rate. This is the fee charged each month by the lender for borrowing money. The amount is a percentage of your overall loan. A lower interest rate can be a good thing and the main motivation for refinancing your student loans. But, a lower interest rate does not mean you pay a significantly smaller amount, nor does it mean you will save a lot of money.
The Drawbacks of Refinancing Federal into Private Loans
Refinancing student loans can rob you of benefits and money depending on the type of loan.
The Problems with Refinancing Federal Loans
If you refinance federal student loans, you will lose access to all federal repayment benefits. This includes low, fixed interest rates, the four income-driven repayment plans and public service loan forgiveness. You lose these benefits when you refinance your federal loans into private loans because refinancing changes the terms of the loans in addition to the lender.
Federal loans offer the widest array of deferment and repayment options for student loans. If you are working in public service, have a low income or could lose your job in the near future, do not refinance your federal student loans.
The Problems with Refinancing Private Loans
The interest rates on private student loans are based on your credit score. Many private loans have variable interest rates.
You may be able to refinance your private student loans into a new private consolidation loan or into a home equity loan with a fixed interest rate. However, the new loan might no longer be eligible for the student loan interest deduction on your tax returns.
When refinancing into a private consolidation loan, it is common to increase the length of the loan to reduce the size of the monthly payment. However, increasing the term of the loan will also increase the total cost of the loan.
Pitfalls of Refinancing for All Types of Loans
There are several additional pitfalls that affect student loan refinancing in general.
- A lower interest rate does not yield a much lower payment. The lower monthly payment usually comes from increasing the length of the loan, which also increases the cost of the loan. Refinancing for this reason might not save you much money, if anything.
- Refinancing all of your loans into one can be a huge mistake. You can choose to refinance some of the loans instead of the whole bundle. Making one payment a month instead of several is not worth losing a low interest rate on some of your loans. In addition, refinancing will prevent you from saving money by paying off the highest interest rate loans first.
- A shaky credit score is detrimental to refinancing, especially since all of the refinancing options are with private lenders. Private lenders use credit underwriting to determine eligibility for their loans and the interest rates. They may require a creditworthy cosigner, such as your parents. Cosigning a loan makes the cosigner equally obligated to pay the debt back.
- If your student loan balance is $10,000 or less, refinancing is not worthwhile. The savings will be minimal to obsolete in the time it will take to pay off such a small amount.
Consider Refinancing Carefully
Refinancing student loans is a major financial move. You are taking out a new loan and resetting the clock for paying off debt. Do not be swayed by the bright and shiny ads that make too many promises.
Know that refinancing does not always save you money. Know the type of student loans you have and do your research before jumping into refinancing. The goal is to pay off your student loans as soon as you can and to save as much money as you can. Refinancing is not always the best option to get there.