From the Clipboard - Refinancing student loans | Tempted by the rate to refinance?
Given that interest rates are so low right now, have you been getting
those really low interest rate offers? You may be wondering what to do. Let's talk about what other factors you should be considering.
Recently, I've been getting a lot of questions wondering if they should refinance. Given that interest rates are so low, it might be a good time to take advantage. Before you rush off and do this, think about the other factors because, quite frankly, the interest rate itself is one of the last factors you want to consider.
To begin with, let's define the terms “refinance” and “consolidate”. Often, people use them interchangeably but they are very different.
Consolidation refers to using a Federal loan, a Direct Consolidation loan, used to consolidate other Federal loans. It can be done by either the students or parents. The interest rate on a Federal Consolidation loan is
the weighted average of the loans you consolidate. For example, if you have
two Federal loans 2% interest each, the interest rate on the consolidated loan is the weighted average, or 2% in this case, plus ⅛%.
Often, borrowers don’t take advantage of consolidation because they want to keep a low interest rate on an old loan or think that interest rates would be much higher due to other factors, such as credit score.
Then there's refinance. Refinance is using a private loan from a bank or other non-Federal government lender that you use to pay off other loans, either Federal or private. You may see ads for this on the internet, on TV or other media outlets.
The factor that gets the most attention is the interest rate. But what is the interest rate you’ll get? With private loans, unlike Federal loans, you have the choice to fixed or variable. And a number of repayment terms. Generally speaking, the advertising showing a really low rate is for a variable rate, with the shortest repayment term, offered to the people with the best credit scores and highest debt to income ratios.
What is the impact on your payment though? Even with a lower rate, your payment may be higher due to a potentially shorter payment term. Yes, the total amount of interest you pay over the life of the loan may be less, but the payment itself may not be affordable for you.
Federal student loans offer many different repayment plans unlike any other loans in our economy. You can change from a Standard, 10 year repayment to an Income Driven plan to an Extended plan with a 25 year period to a Graduated and back again. There are some qualifications for certain plans, but otherwise have no restrictions on changing repayment plans at any time.
As an example, if you had a 15-year mortgage but need some temporary payment relief, you can't just send a lower payment for a few months arbitrarily. Normally, to reduce your payment, you would have to refinance which means you would have to re-qualify, get an appraisal, and potentially pay closing costs. and everything else that goes into that process.
Some private student loans do offer some options, such as a 10 vs 15 or 20 year repayment plan. However, there's certainly no income driven plan with private student loans.
Another major difference is something that’s been in the news often - loan forgiveness. Wth private loans, there is no formal forgiveness program, though there are situations that may allow for forgiveness or cancellation. Some lenders may forgive due to death or permanent disability under the umbrella of “compassionate consideration”.
Federal loans offer programs to eligible borrowers such as Public Service Loan Forgiveness or Teacher loan forgiveness. Note, however, that an across the board loan forgiveness is a complicated issue.
Another key area to consider is forbearance (in non-pandemic times). You lose your job, or become disabled and need a break on your payments for a period of time. Many private student loans do have this
feature but vary greatly in length of time offered. I've seen some lenders only offer 12 months worth of forbearance over the life of the loan while others offer as many as 48 months.
Federal loans generally limit forbearance to 36 months, though there are so-called “Mandatory” forbearance programs related to medical or dental school residency/internships, National Guard service, and even if the total of your Federal student loan payments exceed 20% of your gross monthly income.
An interesting note about deferment is the treatment of Direct subsidized loans. These loans do not accrue interest during school though would as the student enters repayment. However, the subsidized provision doesn’t go away - if a student re-enters deferment later on, whether due to going back to school or loss of job, these loans will not accrue interest during that time.
Again, it is something that is not available on any other type of loan in our economy.
Don’t forget, though, you can’t go back. While I am not opposed to refinancing or using private loans, the key to remember is that once Federal loans are paid off, you can’t go back. There is no mechanism to use a Direct Consolidation loan to pay off private loans.
The key question is whether getting a lower rate by refinancing is worth losing these other provisions. Each borrower will have to answer for their own circumstances, but clearly the answer is not just about rate.
I write primarily on college financial aid and retirement planning topics. My firm has a particular specialty in working with self-employed or small business owners on these issues.
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