8 Tips for Refinancing Student Loans
The Refinance Option
It’s official: student loan debt is nothing short of an epidemic in the United States. With millions of students and recent graduates struggling to make payments, one wonders how long it can go on. However, the situation is not completely hopeless. For many Americans who worry about making student loan payments, refinancing is a legitimate option. Refinancing can put help money back into your pocket and give you a greater sense of financial freedom and security. Before we get into the nuts and bolts of refinancing a student loan, let’s take a look at what it means to refinance, and who is eligible to do it.
What does it mean to refinance a loan?
In essence, refinancing simply means replacing one debt obligation that has a certain set of rules and terms with another debt obligation under different rules and terms. In most cases, the main purpose of refinancing is to find a lower interest rate that will save you money in the long-term. However, debt can also be reorganized into multiple loans to be paid off at different intervals, or loan extensions that ensure smaller, more manageable payments.
For example, let’s say you take out a 10-year, $20,000 loan, with an interest rate of 8%. To pay off the loan in 10 years, you will need to make payments of around $250 per month. Assuming that the interest is compounded annually and you make a set minimum payment of $250 every month, by the time that all is said and done, you will have paid close to $30,000 in total.
Here is a breakdown of the approximate annual interest you will pay for each year of the loan:
- Year 1: $1600
- Year 2: $1488
- Year 3: $1367
- Year 4: $1236
- Year 5: $1095
- Year 6: $942
- Year 7: $778
- Year 8: $600
- Year 9: $408
- Year 10: $201
- Total Interest Paid: ~$9,715
Needless to say, paying almost 50% more than the value of the initial loan is not ideal, even if it is spread out over 10 years. This is why so many people turn to refinancing.
When you refinance, a lender pays off the remainder of your loan and replaces it with a new one with better terms. Using the example above, let’s say that you have been paying off your existing loan for about two years when you decide to refinance. At this point, you have already paid approximately $2,000 in interest, and the principal balance will be somewhere around $17,000.
With the new loan, the terms are as follows: you will pay off a principal balance of $17,000 in 8 years, with an interest rate of 5%. The new minimum payment will be $220 per month. Let’s break down the new interest rate to see how much you will save:
- Year 1: $850
- Year 2: $760
- Year 3: $667
- Year 4: $567
- Year 5: $464
- Year 6: $355
- Year 7: $241
- Year 8: $121
- Total Interest Paid: ~$2,000 (from previous loan) + ~$4,025 = ~$6,025
So, thanks to a lower interest rate, you were able to save around $3,690 in interest payments. Of course, this is still assuming that you want to pay off your loan in 10 years, however, many people refinance so that they can pay off their loans early. Let’s look at what would happen if you refinanced the same loan (using the new terms outlined above), but instead of making the new monthly payments of $220, you decide to continue making payments of $250 per month:
- Year 1: $850
- Year 2: $742
- Year 3: $629
- Year 4: $511
- Year 5: $386
- Year 6: $255
- Total Interest Paid: ~$2,000 (from previous loan) + ~$3,373 = ~$5,373
In this scenario, you were able to pay off the loan two years early while still making the same monthly payments as you did with the original loan. Additionally, you paid close to 50% less interest over the course of the loan.
As these examples demonstrate, refinancing a loan can really ease the burden of debt. Whether you want to make smaller monthly payments, pay off your loan early, or simply pay less in interest, refinancing is one of your best options.
Who Can Refinance a Loan?
The four most common debt types that can be refinanced are student loans, credit card debt, mortgages, and auto loans. However, not everyone will be eligible to refinance. Generally speaking, banks will look at the following factors to determine your ability to qualify:
- Credit Score – Your credit score is possibly the most important factor when determining your ability to refinance. Do you have a history of paying your bills on time? Do you have ample room on your credit cards? Do you have multiple accounts and/or loans in good standing? If so, you will probably have a healthy credit score and a much better chance of refinancing your existing debt. For most loans, you will need a credit score of at least 620 to refinance, and higher than 700 to qualify for the best interest rates.
- Adequate Income – This sounds relative, and it is. If you’re trying to refinance a $100,000 loan, and you make less than $25,000 per year, the bank may determine that the risk is too high and decline your request. Banks and lenders want to be sure that you make enough money to be able to pay back the loan before they decide to take on the risk.
- Sufficient Equity – While not as relevant to student loans, equity is a major factor when refinancing a mortgage or auto loan. In essence, equity is the amount of something (house, car, etc.) that you own after accounting for debt. You can determine equity by subtracting the loan balance from the market value of your house, car, or similar investment.
In order to refinance a student loan, you must have a decent credit score and income. You do not need to have stellar credit or be making six-figures, but you will need to show that you are financially responsible and capable of paying your bills.
So, now that we have defined what refinancing is and who can do it, let’s take a look at the 8 things to be aware of when refinancing student loans.
Number 1: The Sooner the Better
When it comes to refinancing student loans, it is best to start the process as soon as possible. As the above examples demonstrate, you will spend the most money on interest in the first few years of a student loan. Therefore, refinancing to a loan with a lower interest rate quickly can save you thousands. In addition, paying down your student debts quickly allows you to allocate more funds for savings, which could even help you get to your retirement earlier than expected.
Number 2: Smaller Payments Cost More
If you want to refinance your student loans to make smaller payments, this will inevitably extend the life of your loan and, depending on the new interest rate, potentially cause you to pay more in the end. Always do the math before refinancing to ensure that you are not just adding more to your debt obligations. If you want to make smaller monthly payments AND pay less in interest, you will need to find an interest rate that is significantly lower than your current one.
Number 3: Federal Forgiveness Programs
Federal debt forgiveness programs help students with government-funded loans ease the burden of their debt. If you have been paying down your loans for a certain period of time (generally a decade or longer), you may be eligible for various debt forgiveness programs. These essentially reduce or completely wipe away the remaining debt that you owe. However, if you refinance a loan (i.e. switch from a government-funded loan to a private lender), you are no longer eligible for these programs. Additionally, these programs usually have strict requirements regarding your payment history, so you must make all of your payments on time if you hope to qualify.
Number 4: Low Credit Scores for Students
Many students fall in the 18-35 age range, meaning that they have not had much time to build up a strong credit score. As a result, most students will not qualify for the best interest rates, and may not be able to save as much as they would have hoped. Building credit takes time, so if your credit is not high enough to secure a decent interest rate (and you cannot secure a cosigner), refinancing may not be the best option for you. Instead, you might consider making cuts to other parts of your budget in order to pay more than the minimum each month. This way, you can pay off your student loan early.
Number 5: Cosigners
For those with poor or even no credit, a cosigner is a great way to meet a lender’s refinancing requirements, without taking the time to build up your credit score. Lenders will look at the cosigner’s credit and income to see if they would qualify for the same refinancing plan. Needless to say, you will need to find a cosigner who has good credit and sufficient income in order to qualify for better interest rates. This is a common method for recent graduates, who can often have a parent or other family member cosign.
Number 6: Borrower Protections
Federal student loans offer various protections for borrowers, including deferred payments and varied monthly payments based on current income. However, many private lenders do not afford students the same protections, and the terms of a loan can vary widely between lenders. Therefore, it is vital that you know your rights and understand how refinancing will affect you. If you rely on the privileges of a government-funded loan, it may be in your best interest to keep it, rather than switching to a private lender and losing some important protections.
Number 7: Comparing Rates
Even if you have sufficient income and a good credit score, interest rates will vary between lenders. It is important to shop around in order to find the best rates (and terms) for you. Additionally, some lenders are willing to lower interest rates a little when you set up automatic payments, because it assures them that you will be able to make your payments on time.
Number 8: The Fine Print
It goes without saying that refinancing a student loan is a huge undertaking. It should never be done rashly, and there are various factors that can affect the amount you save and the time needed to pay off the loan. Most lenders require you to read and sign a great deal of paperwork, but it is important to take this part seriously. If you don’t, you could be stuck paying off a sub-par loan for years because of tiny details in the fine print.
In short, refinancing can be a great way to cut down your student loan debt. However, it is vitally important to understand the terms and do the math in advance. Lenders tend to push high interest rates and terms that force you to pay more in the long-term, so you will need to shop around and read the fine print before making a decision. Additionally, you must ensure that your credit is stable and provide proof of sufficient income to qualify with any lender.
Do you want to learn more about refinancing your debt? If you think refinancing could help ease the burden of your student, home or auto loan, here are a few of our top student loan lenders for 2019.
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June 3, 2019
Matthew is an experianced FiGuides writer and researcher. He holds B.A. in Philosophy from the University of Georgia and enjoys taking a deep dive on personal finace projects.