I’d like to thank Josh at Family Faith Finance for writing this guest post on a very hot topic for students and recent graduates: Student Loan Refinancing. What is it? How does it work? Is it right for you? Can you still do an income based repayment if you refinance? Keep reading below to find out more…
With the cost of college at an all-time high (and rising), it is no surprise that many Americans have student loans. The burden of paying off student loans is a heavy one, leading many graduates to explore ways to get out of debt sooner rather than later. One of those ways is consolidating or refinancing their student loans, where loans are combined together under new repayment terms.
What is Student Loan Consolidation vs. Refinancing?
Consolidation and refinancing are often used interchangeably when it comes to student loans. They refer to the same general process, but there is some distinction. For instance, the federal government offers student loan consolidation without any opportunity to “refinance” the interest rate, but you can restructure your loan repayment term (length of time to repay). Student loan refinancing typically involves consolidation, but debtors have the chance to get a new interest rate and along with a new repayment structure. This is the key difference between consolidation and refinancing.
With this in mind, consolidation typically refers to federal student loan consolidation. In this process, a borrower can have his or her federal student loans consolidated into a single loan through the United States Department of Education. Federal student loan consolidation can only be used for federal student loans. This process allows borrowers to extend their repayment term, offering monthly relief financially.
In contrast, refinancing is a process where you apply for a new loan from a private company. This loan pays off one or more existing student loans. It can be used for both private student loans and federal student loans, combining them together into one private consolidated loan. Through refinancing, the borrower obtains a new interest rate which is hopefully lower than the average of the interest rates on the old loans.
The main incentive (and key difference from consolidation) of refinancing student loans is getting a lower interest rate. The new interest rate is based on an underwriting criteria based on income, credit score, history of making on-time payments, and other factors. Federal student loan consolidation does not generally result in a lower interest rate. Instead, the new interest rate is a weighted average of the old loans’ rates. A refinanced student loan term can be anywhere from five to twenty years. Consolidated federal student loan payment terms can be up to thirty years.
Why Would You Choose to Refinance?
If you currently have high or variable interest rates on student loans, you may be interested in exploring refinancing in order to reduce those interest rates or obtain a fixed interest rate. This is particularly important in 2017 since the Federal Reserve raised interest rates causing variable interest rates to rise as a result. Because refinancing involves obtaining an entirely new loan that is based on your creditworthiness as a borrower, the best time to apply for refinancing is when you have an established credit score and history.
To qualify, your credit score must be at least in the mid 600’s (660 or higher), and you must be employed with a steady income. Even then, you may not get the ideal terms to warrant refinancing. Some banks may have additional requirements for approving a refinanced student loan application. Keep in mind that if you choose to refinance your federal student loans along with your private student loans, you will lose the protections of those federal student loans such as loan forgiveness options and access to income-driven repayment plans.
Why It’s Worth It
Ultimately, student loan refinancing should hopefully result in a lower, fixed interest rate for a borrower with a good credit score and a solid income. Over the life of a loan, this can result in savings of thousands of dollars from reduced interest payments, particularly if you choose a shorter repayment term.
For example, if your current student loan interest rate is 6.0% on a $35,000 student loan with a ten-year term, you could save over $2,100 in interest by refinancing the loan to a 4.99% interest rate. It would reduce your monthly payments slightly from $389 per month to $379 per month. If you reduced your loan repayment term for that same loan to 5 years, then you would save over $7,000 in interest payments (although your monthly payments would jump to $660 per month).
The above scenario involves just a one percentage point reduction in your interest rate, so it is easy to see how you could save thousands of dollars on your student loans — and potentially pay off your loans much more quickly — by taking advantage of student loan refinancing.
By Josh Wilson, a Millennial working to become his generation’s personal finance thought leader. Josh dreams of a day when all Millennials can thrive through financial literacy and patience. Josh writes for the blog Family Faith Finance.