Now Could Be the Right Time to Refinance Your Student Loans
There has been a growing concern around student loan debt for quite some time. The New America Education Policy Program reported in 2012 that about 40 percent of all student loan debt was from graduate students.
Why is this important? One in four borrowers took out more than $100,000 in loans, according to the study, and interest rates for graduate programs can be 50 percent higher than what their less-leveraged undergraduate counterparts can expect.
Is there anything you can do about your federal or Direct PLUS student loan debt?
1. Take no action. Depending on your interest rate and financial situation, you may be best suited to take no action at all. Refinancing or consolidating will limit flexibility in the future for loan deferment, forbearance and forgiveness. Since there is no prepayment penalty, you have the flexibility to make additional payments to the principal of your loan as your income changes without getting locked into a higher monthly payment.
2. Consolidate. Designed to help simplify payments on multiple loans, some borrowers decide to consolidate their loans into one. By consolidating your loans, a new interest rate will be applied, based on the weighted average of the loan balances and associated interest rates. This approach is typically not advisable as it usually costs more over the life of the loan and limits your ability to refinance only a portion of the loan in the future. Since automatic payments can be set up and managed easily online, there is little need for consolidation.
3. Refinance. The decision to refinance student loans can save some borrowers thousands in interest expense over the life of the loan. Similar to most credit applications, your eligibility and rate will be determined by numerous factors, such as your income, credit score and total outstanding debt. Strong candidates can see a dramatic reduction in their interest rate -- even a few points. It isn't right for everyone though, and there are some very important caveats to consider. With only a few exceptions, it is generally advisable for all student debt holders to at least explore a refinancing scenario. Depending on how long you've been out of school, your annual income and credit history is likely to have improved. One of the main factors for the interest rate you may qualify for is current market interest rates, which are currently very low.
Why doesn't everyone refinance?
There are a few good reasons why refinancing isn't for all borrowers. Many of the big student loan refinancing lenders only consider candidates with excellent credit and income profiles, sometimes even limiting which academic institutions are accepted. Refinancing also tends to cost more in the short term, which not all borrowers can afford. Refinancing typically requires the borrower to enter into a shorter repayment period, often five to 15 years. Even with a reduction of one or two points on your interest rate, shaving five to 10 years off the life of the loan may result in monthly payments outside your current budget.
Refinancing federal student loans to a private lender also has lesser-known implications. Federal loans have benefits such as loan deferment and forbearance, which can help a borrower when they're having financial struggles. Depending on which you qualify for, you may be granted a period in which you can defer all loan payments, or at least only pay interest. When refinancing to a private lender, you lose these options, along with student loan forgiveness. Finally, if someone dies with outstanding federal loans, the balance is forgiven. With private lenders, this isn't necessarily the case, especially if there is a co-signer on the loan.
If you're financially secure and think refinancing could benefit you, shop around a bit to find the best rate. That ultra-low variable rate may look appealing, but for the vast majority of borrowers, the risk isn't worth the reward, especially for those carrying high balances. If you have multiple loans outstanding, it probably makes sense to start with the highest balance or interest rate. Trying to tackle all your loans at once may not be feasible, but depending on the amount of debt, you can still save thousands by choosing one.
Most refinancing lenders don't charge any fees to refinance, and some even offer bonuses. Before signing on, be sure you're comfortable with the terms and check if there are prepayment penalties, as you may want to put a bonus towards your loans or refinance again in the future. As a final consideration, ensure the new monthly payment is within your budget and doesn't derail any other financial goals. If you're saving up for a down payment on a home, you may not want to divert an extra couple hundred dollars each month to your loans should your payments increase.
While interest rates remain low, consider your financial situation and whether it could be a good opportunity to refinance student loan debt. While the stock market cannot guarantee returns, by locking in a lower fixed rate on your loans you can actually calculate a guaranteed rate of savings over the original loan. As part of a diversified savings and investment approach, capitalizing on historically low rates by refinancing existing debt could be a good option for investors of any risk tolerance.
Kristin McFarland is a blogger for The Smarter Investor and director of strategic partnerships at Darrow Wealth Management, an SEC registered investment adviser in Massachusetts. The material contained in her articles is for general information only and should not be construed as the rendering of personalized investment, legal, accounting or tax advice. You can connect with her on LinkedIn and follow her on Twitter.