Ask these 4 questions before you refinance your student loans
Americans now have more than $1.2 trillion of student loan debt.
To help people deal with their debt burden, credit unions, banks and Silicon Valley startups have introduced loans that can be used to refinance existing student loan debt. Companies life SoFi advertise that borrowers save an average $18,936 when they refinance their debt. And SoFi isn't the only company to offer low interest rates. Interest rates start as low as 2.13% (variable) and 3.25% (fixed).
But before you sign on the dotted line, make sure you ask yourself these four questions.
1. Do you have federal or private student loans?
If you have federal student loans, you are probably eligible for income-driven repayment options from the federal government. With an income-driven plan, the federal government will review your tax return and will cap the monthly payment to a fixed percentage of your discretionary income. Depending upon the plan, your monthly payment could be capped to between ten and twenty percent of your discretionary income. You would continue to make payments for up to 25 years, depending upon which plan you use. At the end of the repayment period, any remaining loan balance is forgiven.
Just remember that you have to renew your enrollment every year. If your income increases, so does your payment. And if debt is forgiven, you will owe taxes on the amount that is forgiven. If your income is low enough, your payment could be as low as $0 per month.
Your interest rate on your federal loans will likely be much higher than the interest rate being made available by companies that refinance the debt. You should think of the higher interest rate as an insurance premium. If you have a high level of confidence in your ability to repay your student loans quickly, and you have an emergency fund in case of job loss, you might not need to worry about income-driven plans. Just think long and hard before making a decision.
2. Do you have a good credit history and verifiable income?
If you want to refinance your student loan debt, you need to have an excellent credit history. Only people with an excellent credit history and good income can qualify. Lenders will look at your credit report and will want to see a history of on-time payments, especially with your existing student loans. In addition, most lenders will perform an analysis of your cash flow and will want to verify your income. Most lenders are targeting "HENRYs," which are "high earners, not rich yet." If that describes you, refinancing your debt could make a lot of sense. But if you are struggling to make your payments or have a bad credit history, you would likely be rejected.
3. Do you want a fixed or variable rate?
Variable interest rates are much lower than fixed interest rates. For example, earnest, a Silicon Valley startup, charges variable rates between 2.13% - 5.41% and fixed rates between 3.50% - 7.05%. If you can pay off your debt quickly, you might want to take advantage of the low variable rates. However, if you think it will take 15 or more years to eliminate your debt, you will probably want to lock in a fixed rate. This is ultimately a risk-reward calculation that only you can make.
4. Have you shopped around for the lowest interest rate?
There are a lot of companies offering to refinance your student loans, and you should apply to as many as possible. Use a website like MagnifyMoney to compare the many companies that offer the product. And make sure you complete all of your applications in a month. FICO treats all student loan inquiries within a 45 day period as a single inquiry. So you should feel comfortable shopping for the best rate without worrying about the impact on your score. Just remember that if you are planning to apply for a mortgage in the next six months, you might want to hold off on shopping around for a refinance option, because even a single inquiry can have a big impact on your mortgage rate.
For many people, student loan debt is a big burden. Like any other form of debt, the interest rate will have a big impact on how long it will take to pay off the debt. The lower the interest rate, the quicker you can get out of debt. Just make sure you take advantage of the lower rate by reducing the term of your loan. Your goal should be to eliminate the debt as quickly as possible.