Understanding the Risks of Refinancing Your Student Loans

When you have student loans, you have a lot to worry about. Tracking your spending and keeping payments on schedule can be difficult enough, especially if you need a mountain of documentation for a federal relief program like PSLF. Relief options like consolidation, refinancing, and income-driven repayment are a big boost for borrowers, but doing the legwork can sometimes feel like a part-time job. Plus, some relief options only provide brief respite now at the expense of pain later. 

Take refinancing for example. Getting a better interest rate on a loan seems like a no-brainer, right? Especially if your credit score has gone up 100 points or more since you borrowed the money. Well, not so fast my friend. Refinancing even a single loan requires some deliberation on the pros and cons. A refinanced loan can send reverberations into your financial future and limit your choices down the line. Make sure you consider ALL options before refinancing, especially if you have a combination of federal and private loans.

How Does Refinancing Work?

Refinancing a loan isn’t as complicated as you might think. When you refinance, you simply pay off an existing loan by using a new loan with better terms. For example, if you replace a $20,000 loan at 8% with a $20,000 loan at 6%, you’ll save over $2000 if you pay the loan off in 10 years. (Use Bankrate’s loan calculator to play around with your own loans). Why would your interest rate on the new loan be lower? Here’s a few reasons:

  1. Your credit score has gone up
  2. Your debt/income ratio has gone down
  3. You’re adding a co-signer to the new loan

If you’ve put a dent in your debt load while raising your credit score, a refinanced loan could help get your finances under control. But like I mentioned before, refinancing carries its own set of risks. Especially if you depend on federal relief programs.

Risks of Refinancing

Refinancing can save money in both the short and long-term, but only in certain situations. If you have federal student loans, you have access to certain protections and programs that private borrowers do not. Income-driven repayment, the Public Service Loan Forgiveness program, and loan forbearance are all helpful programs for borrowers who struggle to make timely payments. The government also offers a consolidation program for borrowers with different kinds of federal loans, but refinancing isn’t an option. If you want to refinance your loans, you’ll need to turn to a private lender.

Very few private loans have the same protections as their federal counterparts. There’s no loan forgiveness or income-driven repayment. You also can’t put them on hold if you lose your job. This is why so many borrowers only turn to private lenders as a last resort. The banks want ALL their money back and don’t care if you fall on hard times. When you refinance, you’re turning your loans completely over to these private lenders and abandoning all federal relief options. That means no loan forgiveness, no income-based payments, no deferment if you go back to school, and no forbearance if you get laid-off or fired. Your current loan type is irrelevant – they all become private loans after refinancing.

Who Should Refinance?

If you only have private loans, refinancing should be on your radar. Getting a lower interest rate is always a good idea when federal relief programs are off the table. However, if you have federal loans or a mix of federal and private, refinancing might not be in your best interests. Only consider refinancing in the following situations:

  • You’re Ineligible for Loan Forgiveness – Government workers and other non-profit employees can have their federal loans forgiven through the Public Service Loan Forgiveness program. If you’re a teacher, police officer, member of the armed services, or federal employee, check your eligibility for PSLF before refinancing any loans.
  • You Only Qualify for Standard Repayment – Federal borrowers making below a certain salary threshold can enter an income-driven repayment plan like REPAYE. Income-driven repayment plans take only a portion of your discretionary income each month to pay your loans. Then, after a certain length of time, your remaining loan balance is forgiven. If you make enough money that you only qualify for the standard 10-year repayment, you should consider refinancing.
  • You Have a Secure Career or Income Stream – If you lose your job, federal loans can be put in forbearance until you begin working again. But when you refinance through a private lender, that luxury vanishes. Make sure you have plenty of job security (or at least ample savings) before refinancing federal loans with a private lender.

Remember, refinancing only makes sense if you can’t access federal relief programs AND you can save significantly through a lower interest rate. Even a rate drop of 1% could save you thousands of dollars when extrapolated over the life of your loan. But don’t trade short-term relief for long-term grief! If you’re depending on federal relief programs to make your debt burden manageable, refinancing is probably not worth the risk. Once you’ve refinanced your federal loans with a private lender, there’s no going back to Uncle Sam. Be sure to weigh all the benefits and drawbacks before making a choice. Besides, the banks aren’t going anywhere.  You can always change your mind and refinance at a later date.

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