Mailbag: Good Job but Lots of Debt, Should I Refinance?

Michael Lux Blog, Mailbag, Refinance, Strategy, Student Loans 0 Comments

Making the decision on whether or not to refinance your student loans can be very challenging.  On one hand you have the low interest rates offered by the refinance companies, but you are forced to give up federal perks.  One of our readers, Brad, is currently facing this dilemma.  He has a great job, but also has a lot of federal student debt, so it is a high stakes decision.  If you have a question for the Sherpa, feel free to ask us!

Brad writes:

Hey Sherpa,

I ran across your website while I was looking at reviews for CommonBond. I just graduated pharmacy school a few months ago and began working at a national chain pharmacy.  My base salary is 98K and I received a 20K signing bonus. I’m lucky that my parents paid for my undergrad loans but all the pharmacy stuff is on me. With that being said, my loan amount is about 165K. I’m trying to decide wether refinancing is good for me or do I just stick with paying through the government.  I rent currently but would like to purchase a house possibly within the next year. I guess my biggest issue is trying to decide what term to select for paying back if I was to go through a private lender. I’ve been mostly looking at either a 10 or 15 year repayment plan. Two companies have my interest rate is below 5% for a fixed rate. I do not want a variable rate. I know this is quite a lot but I want to make a good decision. How do you decide wether or not to refinance?

Thanks,

Brad

Refinancing vs. Sticking with the Government

If you have private student loans, refinancing is a no brainer.  If you can get a lower interest rate, you refinance.

Things are much more tricky with federal debt.  Refinancing your federal student loans can be a really smart move or it can be a major financial mistake.

The benefit to refinancing is getting lower interest rates.  If Brad can lower his interest rate by a single percentage point, it would save him nearly $140 per month in interest.  A three percent drop would be a savings of well over $400 per month!  The lower interest rate also means more money to be applied to principal each month.  If Brad wants to aggressively pay off his debt, it will happen much quicker by refinancing.

However, the downside to refinancing can also be quite extreme.  The federal student loans that Brad currently has come with great borrower protections.  These include repayment plans based upon income and student loan forgiveness programs.  With Brad’s current work situation, he will not need these federal protections.  However, if he loses his job, having the option to make payments based upon his income will be extremely helpful.

For many the best way to weigh this decision is to look at it from an insurance perspective.  The federal loans will cost extra due to higher interest rates — if they don’t, you definitely should not be refinancing.  Do some quick math to see how much extra you will be spending each month to keep federal loans.  If brad can save himself $100 a month by refinancing, the question becomes, am I willing to pay $100 per month to have the federal protections?  If he thinks he has a stable job and will easily be able to find a new job if necessary, he might value the federal perks at only $10 or $20 per month.  If he is terrified about the possibility of having the debt with no way to pay it, he might value the federal protections at $200 per month.

Once you decide what you are wiling to pay for federal perks, you can compare it to your potential savings.  Then the complicated decision is a little bit easier to decide.  Close calls should always stay on the side of sticking with the federal protections.

Selecting a Loan Term

If Brad decides to refinance, the term selection will have a huge impact on his finances.  Opting for a shorter term means a lower interest rate, but higher monthly payments.  The long-term loans have higher interest rates, but the lowest monthly payments.  A five-year refinance loan has interest rates starting just over 2%, while a 20-year fixed-rate loan starts at about 5%.

The trick is to find the sweet spot between interest rate and monthly payments.  Most student loan refinance companies will let you see what your interest rate will be for various different loans, so you don’t have to guess which length will be best.

One final thing to keep in mind is Brad’s desire to buy a house.  This goal means his debt-to-income ratio should be a major concern.  If his monthly bills eat up a huge portion of his monthly income, it will be harder to qualify for a mortgage.  Opting for a longer loan means Brad gets a lower monthly payment, and potentially increases his home buying ability.

Deciding to Refinance

With Brad’s high debt and high income, this decision will have a major impact on his future.  There are several items that Brad will need to consider before making his decision.

  • How secure is his job and employment?
  • How soon does he plan on buying a house?
  • How will his student loan decision impact his ability to buy his house?

One factor in this decision that we haven’t discussed is the potential monthly payments on a refinanced loan versus the monthly repayments on an income-driven repayment loan, such as Revised Pay As You Earn.

If Brad refinances $165,000 at 5% over 20 years, his monthly payment will be about $1088 per month.

If Brad enrolls his federal loans in the Revised Pay as You Earn Plan, his monthly payments will be less than $700 according to the federal repayment estimator.

Despite the lower monthly payments on the federal loan, it is the more expensive option, because a much higher percentage of his $700 payment will be going towards interest rather than lowering his principal balance.

However, the nearly $400 per month difference in monthly payments could impact his ability to get a mortgage for the house he wants.

The Options

Brad’s first option is to not refinance at all – This option makes the most sense if Brad is concerned about his longterm ability to continue earning 98K per year.

Option two is to refinance right away – As long as Brad is confident he will be able to continue earning a solid income, this option will be the one that saves the most over the life of his student loans.  As Brad pays down his debt or earns more money, he can refinance multiple times in the future each time he is able to get a lower rate.

Option three is to enroll his federal loans into an income-driven repayment plan, get the lowest possible monthly payment, buy a house, and then refinance – This option is best if buying a home is Brad’s biggest priority.  If he goes this route, he will spend more on student loan interest in the short-term, and buying a house could make it more difficult to refinance his federal loans in the future.  This option could be very expensive.

Final Thoughts

Ultimately, the decision comes down to more than just the math.  Brad must account for how much risk he is willing to tolerate and how strong is desire to buy a house is.

There isn’t really a right answer or a wrong answer.  The key is the process.  Brad must give serious thoughts to all of his goals.  He should check is rates with several different lenders to make sure he knows his refinance options.  His decision should be based upon his personal circumstances and his objectives.