Lenders that refinance student loans often advertise that borrowers save tens of thousands of dollars by refinancing their student loans. The savings figures are based on the average estimated reduction in total payments over the life of the loan. Are these savings real, or is this just a marketing gimmick?
In reality, most of the actual savings comes from having higher monthly payments over a shorter repayment term, not the reduction in the student loan interest rates. Borrowers can get most of the savings without refinancing their student loans.
Keep in mind that refinancing federal student loans means a loss in many benefits that only federal loans offer. These include an option for potential loan forgiveness, income-driven repayment plans, generous deferment options if you become unemployed or have an economic hardship, and an option to discharge loans for death or disability.
Impact of higher monthly loan payments
Refinancing a private student loan often involves a shorter repayment term in addition to a lower interest rate.
Fixed-rate loans are priced to yield the same net interest revenue to the lender as a variable-rate loan over a specified period of time. In a rising-rate environment, lenders limit fixed-rate loans to a shorter repayment term, to keep their costs from increasing too much. Choosing a shorter repayment term also allows the lender to advertise a lower interest rate.
A shorter repayment term also means making higher monthly loan payments.
Loan payments are applied first to the interest that has accrued since the previous payment. Any money left over pays down the principal balance. So, increasing the monthly loan payment causes the principal balance to be paid off quicker, which also reduces the total interest paid over the life of the loan.
Impact of lower interest rates
Borrower intuitions concerning interest rates are often incorrect.
A percentage point or two reduction in the interest rate is not going to have a big impact on the monthly loan payment.
For example, consider an 8% loan with a 10-year repayment term. Cutting the interest rate by two percentage points to 6% yields an 8.5% reduction in the monthly loan payment. For example, on a $10,000 loan this reduces the monthly payment from $121.33 to $111.02, or about $10 a month.
Many borrowers incorrectly believe that cutting the interest rate on a student loan in half will cut the monthly payment in half. This isn’t even close to being correct. On a 10-year term, cutting the interest rate in half will reduce the monthly payment by 10% to 20% for typical interest rates. On a 25-year term, it cuts the monthly payment by a fifth to a third.
Cutting the interest rate on a loan in half yields about the same reduction in total payments over the life of the loan as cutting the repayment term in half.
Real impact of refinancing a student loan
Suppose you owe $50,000 at 8% with a 25-year repayment term, and are able to refinance at 4% with a 7-year repayment term.
Your monthly payment will increase from $385.91 to $683.44 and your total payments will decrease from $115,771 to $57,409.
So, yes, you do save $58,362. But, how much of this is due to the interest rate change and how much to the reduction in the repayment term?
If we change only the repayment term without changing the interest rate, the monthly payment increases to $779.31 and the total payments decrease to $65,462, a savings of $50,309.
If we change the monthly payment to $683.44 without changing the interest rate, the loan will be paid off in 8.4 years (101 payments), with total payments of $68,802, a savings of $46,969.
Obviously, there are synergistic effects, but most of the savings is from the shorter repayment term, not the reduction in the interest rate.
The cumulative interest at 8% over seven years is $15,462 and at 4% over seven years is $7,409, so the savings attributable to the interest rate change over seven years is $8,053. That's only 12% of the $58,362 in savings from the combination of the interest rate and repayment term changes.
Since there is no prepayment penalty on student loans, nothing stops you from increasing the monthly payment by $297.53 to $683.44 and thereby achieving 88% of the savings. Moreover, if you don't refinance, you can target the highest-rate loan for quicker repayment and thereby achieve even more savings.
Although refinancing a student loan at a lower interest rate yields some savings, most of the savings from refinancing a student loan comes from the higher monthly payment of a shorter repayment term.
Borrowers can achieve similar savings by choosing a higher monthly payment without refinancing the loans. The difference in the monthly payment is implemented by making an extra payment to principal each month. Moreover, if this extra payment is made to the loan with the highest interest rate, the savings are even greater.
When making an extra payment on a student loan, be sure to include instructions with the extra payment. Specify that the prepayment is an extra payment and not an early payment of the next installment. Also, specify the loan ID of the loan to which the extra payment is to be applied.