Student debt is growing in the United States. According to the U.S. Federal Reserve, Americans owe more than a trillion dollars in student loan debt and the bills keep piling up.
Students are leaving college saddled with debt from loans with interest rates that eat into earnings, making it difficult to qualify for mortgages and other financing. Fortunately, student loan refinancing is available to borrowers looking for a better deal.
There are pros and cons when refinancing student debt. For this primer, we’ll start by explaining some good reasons to refinance student loans.
How refinancing student loans works
Student loan refinancing is the process of applying for a new student loan that will be used to pay off the existing student loan or loans in full.
The first step in the process is to evaluate your current student loans. Research the interest rates, repayment terms, balances and monthly payments. Then, determine what your goals are: a lower interest rate, lower monthly payment or convenience of one bill.
Evaluate the current market interest rates available and determine a few possible lenders to apply for and see what you can qualify for. If approved and it is better then your current situation, the new lender will pay all your existing loans in full and create one new loan for you to repay.
Reasons to refinance student loans: Pros
Get a lower interest rate
If you have decent credit and income, you may be eligible for a lower interest rate. Donald Kerr, senior manager of student lending at AAA Northeast, notes that a borrower’s earnings typically go up after college and credit scores can improve after college.
“A lot of companies will give an interest rate based on credit scores,” said Kerr. “The better the score and the better the financial situation, the better the interest rate you’ll get.”
Credit score guidelines vary from market lender to lender. “As a general rule of thumb, you want to be above 700,” Kerr said. “The closer to 800 you are, the more likely you are to get some of the lower rates that are advertised.”
Fixed rates in the market currently range from 4 to 10 percent, Kerr said. Variable rates start as low as 3 percent and go up to about 9 percent, he said.
The AAA refinance program, offers a choice to refinance or consolidate students loans with a variable rate and a fixed rate option.
Drop a cosigner, add a cosigner
Refinancing is a good time to add a cosigner to a student loan. “A cosigner can definitely help,” Kerr said.
A student, right out of college, who doesn’t have much credit history, stands to benefit from having a cosigner. “It definitely helps someone who is not strong enough on their own to get a better rate,” said Kerr. “But it doesn’t overrule somebody who has negative credit.”
If you already have a cosigner who you want to release from a loan (or who may want you to release them from a loan) or you want to choose a different cosigner, refinancing provides the opportunity.
A borrower who has a steady job and a decent credit history may refinance on their own. “The student who wants to refinance loans needs to have a well-established credit history and the income to support the loan,” said Kerr.
Consolidation – taking multiple loans and putting them into one – is typically part of the refinancing process if you have more than one student loan.
The advantages of loan consolidation include swapping several monthly payments for one and more repayment choices from different loan terms. If you already have a great rate on one or more loans, you may want to forgo consolidation. Ask your current lender what your rates are and have them compare them to what you can qualify for in the market to determine which rates serve you best.
Lower monthly payments
Lengthening the repayment term of the loan will lower your monthly payment amount. For example, a loan may have a 10-year repayment period. If that period is extended to a 20-year term, there will be more time to pay off the loan and so the monthly payments shrink.
For people who can’t afford their current monthly payments, this can free up needed cash to pay bills and other expenses.
And, now for the “cons” portion of this primer.
Reasons to refinance student loans: Cons
More interest with extended loan term
Kerr warns that lowering your monthly payments can cost money in the long run. “If It adds more years to the loan,” he said. “It reduces the total monthly payment, but increases the total interest paid in the long term.”
Depending on the amount of the loan, this interest could potentially cost a borrower thousands of dollars.
Lost benefits of federal loans
Another downside comes with refinancing a federal student loan through a private lender. If the borrower gives up a federal loan, they lose federal-loan benefits such as active-duty military discounts and loan forgiveness for teachers and public-service workers.
They will also no longer be eligible for the federal income-based repayment (IBR) program, which bases monthly loan payments on a person’s income. “Your payments can be set as low as $5 or $10 a month,” said Kerr. “You usually can’t get that type of plan with a private lender.”
Some private lenders are now starting to offer their own version of income-based repayment, said Kerr, but most do not.