In order to help the economy suffering from the COVID-19 pandemic, the Federal Reserve has in recent months lowered interest rates. The cost of borrowing has decreased as commercial interest rates are lower. Some interest rates like mortgage interest rates have hit 50 year lows.
Federal employees or family members with student loans might be thinking of ways to lower their monthly student loan payments by refinancing their loans. This column discusses whether now is a good time to refinance student loans and some of the mistakes to avoid when refinancing student loans.
Refinancing student loans is the process of either converting federal government student loans into private loans, or refinancing a current private student loan and taking out a new private student loan at a lower interest rate. A lower interest rate is typically the primary reason to refinance student loans. But another reason that student loan borrowers refinance their loans is to merge some or all of their student loan payments into one payment if they have multiple student loans.
What are some consideration when refinancing student loans?
1. Current loan interest rate. If an individual has high interest private student loans, then the individual may want to refinance their loans to a lower interest rate in order to lower their monthly payment.
2. Individual savings. Refinancing may not be a good idea if the student loan borrower cannot get a significantly lower the loan interest rate and/or significantly lower their monthly payment. The “bottom line” is that the student loan borrower has to be able to cut monthly loan repayments costs in some way.
3. One’s credit (FICO) score. If a student loan borrower has a solid credit history, then the borrower is likely to be eligible for more types of student loan refinancing at lower interest rates. The higher one’s FICO score (FICO scores range from 300 to 850), the more lenders the borrower will likely qualify to work with, and at the lowest rates offered. A FICO score exceeding 700 is considered “good to excellent”.
4. Limit immediate credit needs. Since new credit applications trigger a “hard credit inquiry” – the checking of one’s FICO score by potential lenders – a student loan borrower who seeks to refinance their student loans should limit applying for other types of credit, including applying for credit cards, an auto loan or a mortgage. This is because “hard credit inquiries” can lower one’s FICO score and therefore could diminish a student loan borrower’s chances to obtain the lowest interest rate and best possible terms on a new student loan.
Are there any situations when refinancing student loans should be avoided?
There are situations a student loan borrower should not refinance, including:
1. The student loan borrower has only federal student loans. Associated with federal government student loans are many good features that private student loans do not have. One of the more important features is probably the income-driven loan repayment option that will lower a borrower’s repayments based on a percentage of the borrower’s income. Federal student loans also offer: (1) Public Service Loan Forgiveness (PSLF) which is available to borrowers who work for nonprofit organizations, government agencies or other qualifying entities in the public service sector. After 120 qualifying payments, the remainder of one’s loan will be forgiven; and
2. The student loan borrower currently has deferment and forbearance which temporarily suspends the borrower’s payment (without penalty). Both deferment and forbearance will nevertheless result in the student loan accruing interest. Deferment or forbearance has no effect on the loan’s standing. Federal loans typically provide more time to suspend payments than private loans.
Note that refinancing federal student loans to a private loan will result in the loss of the above favorable features associated with federal student loans. The recommendation is to refinance federal loans only if the borrower believes his or her income will be stable throughout the loan repayment period and the borrower will not likely qualify for loan forgiveness options specific to federal loans.
Some student loan lenders allow a student loan borrower to take on a new loan with the help of someone else, a “co-signer”. The co-signer is someone who agrees to sign onto the loan and vouches for the borrower’s credit worthiness. But if the borrower is remiss in paying back the loan, the co-signer will be responsible for paying it back. If neither pays, then both the borrower’s and the co-signer’s credit worthiness will be negatively affected. If a co-signer cannot be found or if the co-signer’s creditworthiness is not good, then the borrower may not qualify for student loan refinancing. A better solution is for the borrower to improve his or her credit score so that a co-signer is not needed for student loan refinancing. That is, the borrower can refinance on his or her own at the lowest possible interest rate and best loan terms.
Those borrowers who have missed payments will likely have problems refinancing their loans. This is because payment history is the biggest determining factor in calculating one’s FICO score. If a borrower cannot afford to make a current payment and has missed payments, then the borrower’s FICO credit score will reflect that and lenders will hesitate to give the borrower another loan.
What are some refinancing alternatives?
If a student loan borrower does not qualify for student loan refinancing at this time, or a borrower is looking for an alternative, the following are some recommendations:
· Get up-to-date on current loans. For borrowers who are behind on their loans, their first course of action should be to bring the loans current again. In so doing, the borrower’s chance for refinancing are improved. It also helps a borrower‘s chances of getting a lower interest rate in the future.
· Make extra loan payments. If possible, the borrower should start to pay the loans more frequently, such as every two weeks rather than once a month. Also, increasing the minimum monthly payment to put more money towards the loan balance will help reduce the amount of interest that will be paid over time, without having to officially refinance the loans at a lower interest rate.
· Apply for an income-driven-payment plan. Those student loan borrowers who have federal student loans can look into income-driven repayment plans. Since these plans are based on the borrower’s discretionary income and the size of the borrower’s household, the borrower will not have to pay more than he or she can afford. This makes good financial sense if the borrower is struggling to make minimum payments on time.
It should also be noted that the CARES Act, passed into law in March 2020 as a result of the coronavirus pandemic, has granted a reprieve to most federal student loan borrowers, suspending payments from March 13 through September 30, 2020. No interest will accrue on most federal student loans during this time. That being said, for student loan borrowers with federal student loans, now would not be the time to refinance these loans because they will lose these temporary benefits. Also, interest rates are likely to remain low for the rest of 2020.
Those employees with private student loans – which are not bound by the federal protections – may want to consider refinancing at this time. Here are some mistakes to avoid in refinancing private student loans:
· Thinking that refinancing student loans is an “all-or-nothing” proposition. There are employees who have both private and federal student loans. They think that they have to refinance all of these loan at once. That is not the case. The private loans can be refinanced and perhaps should be if a lower interest rate and better payment terms can be found.
· Not shopping around for the best rates and terms with private lenders. There is an abundance of private lenders, and not all refinancing offers are the same. Borrowers are encouraged to visit third party comparison sites such as Student Loan Hero, SuperMoney, and LendKey. Note that the interest rate is only one factor to consider in refinancing a student loan. Borrowers should find out whether the loan interest rate is fixed or variable. Borrowers should be sure to ask about a lender’s credit requirements, particularly the minimum FICO score they will consider for refinancing a student loan.
· Going “short term”. Many borrowers like the idea of a short-term loan (less than five years) rather than a long-term loan (more than 10 years). The problem with a short-term loan is even with likely a lower interest rate, the monthly payments are likely to be higher. A short-term loan could be risky if the payments become unaffordable due to a job loss or reduction in income. On the other hand, a longer term loan will in most cases have lower monthly payments. Although more interest will be paid compared to a shorter term loan, the borrower can always choose to pay more than the monthly minimum and end up paying off the student loan in less time. There are no penalties or fees for making extra payments on student loans.