Pitfalls of refinancing student loans
Beware the many pitfalls of refinancing student loans. Federal and private consolidation loans are fraught with hidden dangers and disadvantages that can present much peril for the unsuspecting borrower.
There are seven key disadvantages to refinancing federal and private student loans.
- Refinancing increases the total cost of the loan. If a borrower chooses a longer repayment term when refinancing or consolidating their student loans, as is common, it will reduce the monthly loan payments by stretching out the term of the loan. This increases the total payments over the life of the loan.
- You lose the superior benefits of federal student loans. Refinancing federal student loans into a private consolidation loan might yield a lower interest rate, if the borrower and cosign have excellent credit, but the borrower will lose the superior repayment benefits of federal student loans. Federal student loans provide longer deferments and forbearances than private student loans, as well as death and disability discharges, income-driven repayment plans and loan forgiveness options.
- Refinancing prevents prepayment of the highest-rate loans. Refinancing and consolidating student loans blocks the borrower from targeting the highest-rate loan for quicker repayment. Often, accelerating repayment of the loan with the highest interest rate will save more money than refinancing, especially if most of the borrower’s loans have low interest rates. Accelerating repayment of the highest-rate loan also reduces the average interest rate on the set of loans.
- You may not save money. A consolidation loan only saves money when the new interest rate is lower than the weighted average of the interest rates on the loans included in the consolidation loan. So, even though the new interest rate may be between the highest and lowest interest rates on the old loans, it may not save the borrower any money.
- Most of the savings come from a shorter repayment term, not a lower interest rate. In a rising rate environment, private student loans may offer a very short repayment term, as short as five years, in order to advertise a low fixed interest rate. Although the lower interest rate and shorter repayment term both save the borrower interest savings, most of the savings come for the shorter repayment term, not the lower interest rate. A borrower can achieve a shorter repayment term without refinancing their loans by increasing the amount paid each month.
- A cosigner may still be required to qualify for the loan. Most private student loans, even private consolidation loans, require a creditworthy cosigner. The cosigner is a co-borrower, equally obligated to repay the debt.
- Refinancing resets the clock on refinance. A consolidation loan is a new loan that pays off the loans that were refinanced. The new loan has new repayment terms, resetting the number of years remaining before the debt is paid in full.