Student loans weighing you down? If so, you’ve no doubt already considered refinancing, which means taking out an entirely new private loan to pay off your old student loans, with new terms, new conditions and, ideally, better interest rates.
“Hopefully if you’re refinancing, you’re going to refinance yourself into a better situation, where you’re going to pay less in interest and pay back the loan in a faster period of time than you would have with the original lender,” says Becky House, education and communications director of American Financial Solutions, a nonprofit financial education and credit counseling agency in the Seattle area. “Overall, the goal is that you’ll lessen your debt load.”
Reaching that goal, however, can be a lot harder than it seems. Ask these five questions before deciding whether refinancing is right for you.
1. Should I move federal loans to a private lender?
The hard truth about higher education is that many college students don’t graduate with just one loan — they likely have several, in a mix of federal and private loans.
Refinancing always results in a new private student loan. You can refinance multiple private loans, multiple federal loans or a combination of federal and private debt into a single private loan.
“The big question most people face is, ‘Should I consolidate my federal in with my private?’ ” says Fred Amrein, a Philadelphia area financial planner and developer of college financial planning software. “Understanding your debt structure is critical before you make that decision.”
That's because if you move your federal loans to the private side, you won’t be able to return to the federal side. By refinancing, you're giving up some built-in protections that can come with federal loans. These can include a discharge of your loan due to disability; Public Service Loan Forgiveness, which considers your loan paid off after you’ve made 120 payments if you have a public service job, such as in government, education or the military; and income-driven repayment plans, which set your monthly payments based on your income and qualify you for loan forgiveness after 20 or 25 years, depending on the type of plan you go with (although you may be taxed on any balances that are forgiven).
If it's highly likely you'll want to take advantage of these federal loan perks in the future, you might consider refinancing just your private loans and leaving your federal loans as is, House suggests. You can also check to see if prospective private lenders offer any type of deferment, forbearance or flexible repayment options.
2. How much could I save in interest?
Some borrowers choose to combine their federal loans into a single one through the government's direct consolidation loan program. But if you opt for federal loan consolidation, that doesn't mean getting a lower interest rate — your new rate would be the weighted average of all your old federal loans.
By contrast, one of the biggest appeals of refinancing is the possibility of tapping into an interest rate that is lower than when you first took out your loans. There's no hard-and-fast rule as to what interest rate makes refinancing worthwhile, although House suggests trying for a drop of at least two percentage points.
There are also other factors that play into the total cost of your new loan, such as a loan origination (or processing) fee and the length of the loan. Choosing a longer repayment term can help lower your monthly payment, but you’d ultimately pay more in interest than if you opted for a shorter repayment period with a larger monthly payment.
When you refinance, you'll also have the option for a fixed or variable interest rate (variable rates aren't available for federal loan consolidation). A fixed interest rate locks you into a rate for the lifetime of the debt; a variable interest rate can go up or down over the life of your loan.
Variable rates tend to start out lower than fixed interest rates, although after an introductory period of maybe a month, quarter or year, the rate could go up or down, depending on market conditions. If you prefer the steadiness of a locked-in rate, fixed may be the better option for you. If you plan to pay off your loan in a shorter amount of time or you’re able to keep a low interest rate for an extended period, then choosing a variable rate may be worthwhile.
3. Do I qualify for lower interest rates?
The interest rate you’ll be offered will depend on the loan repayment term you select (typically the shorter the loan term, the lower the interest rate) and your perceived creditworthiness with lenders. They'll be looking at your credit score, your current cash flow and your debt-to-income ratio (DTI), among other factors. The stronger these numbers are, the more favorable loan terms you'll receive.
Credit scores typically range from 300 to 850, and, generally, if you're in the 700s, you can consider yourself in the good-to-excellent range. Not sure how to calculate your DTI? Divide the total amount of debt you owe each month by your monthly gross income. The lower the ratio, the better, although you may hear that a range of 15% to 36% is preferable, depending on whether you have a mortgage.
4. Will I need a cosigner to be approved?
Younger borrowers without much of a credit history may need a cosigner in order to refinance, and who you ask to be yours will be an important choice because “the cosigner and their credit score will have some influence on the interest rate that’s given,” Amrein says.
It's also important that your cosigner knows what they’re signing up for because there's a potential impact on their finances. “They are 100% responsible for repayment on that loan if the other person fails to make those payments,” House says. If you miss a payment, both you and your cosigner’s credit score could be damaged, and the added debt could make it more difficult for your cosigner to qualify for future loans.
Some lenders may enable you to apply for a cosigner release, which releases the cosigner’s debt responsibility if the borrower makes a set number of consecutive payments in full and on time.
5. Will I be able to afford the new monthly payment?
You've likely heard the advice that the best diet and exercise regimen is the one you can actually stick with. Debt works in a similar way: It’s important to choose a loan with a payment schedule that you can actually keep up with.
“What’s absolutely critical in this whole process is you have to pick a method that’s going to keep you current [on your payments], because the penalties and what it does to your credit is absolutely horrible,” Amrein says. According to myFICO.com, a 30-day missed payment has the potential to drop someone with a 780 FICO score to as low as 670. Plus, defaulting on a loan could stay on your credit report for seven years or more.
So whether your goal is to pay the least amount over the life of your loan or to immediately lower your monthly payments, you want to make sure that your new monthly bill is something you're capable of paying. That way, you won't be putting your financial goals at risk.