For many borrowers, student loan refinancing is an excellent option. By refinancing, they are able to get lower interest rates and lower monthly payments.
Unfortunately, student loan refinancing — sometimes called private loan consolidation — is not a magic fix for all borrowers.
The refinance process can have major costs and consequences.
Making things even more serious is the fact that there is no way to “undo” a student loan refinance. Once the refinance lender creates a new loan and pays off the old loans, there is no going back.
Before getting started with a student loan refinance, all borrowers should seriously consider the costs of the process…
Loss of Federal Perks and Protections
The biggest risk to the student loan refinance process applies only to borrowers who decide to refinance their federal loans.
All federal loans come with borrower protections like income-driven repayment plans and student loan forgiveness. Borrowers who lose their job or experience a reduction in salary are able get their monthly payments lowered based upon what they earn rather than what they owe. This means a borrower with $100,000 in student loans could have a monthly payment as low as $0 per month.
Refinancing federal loans means the old federal loans are paid off in full and a new private loan is created. The advantage for borrowers is the lower interest rates that may be available, the downside is that the federal perks are forever gone.
Borrowers who feel they might need the protections offered by federal loans would be wise to only refinance their private loans.
Interest Rates Can Go Up
The lowest rates available from refinance lenders are almost always variable-rate loans.
As economic conditions change, the interest rates on a variable-rate loan will also change. This change could be for the better or for the worse.
For this reason, borrowers would be wise to focus on fixed-rate refinancing, especially for those seeking longer loan terms. The fixed-rate loans generally have slightly higher interest rates than the variable-rate loans, but there is no danger of the rates going up. Should refinance rates drop, borrowers can always refinance a second time with a new fixed-rate loan.
Origination and Prepayment Fees
This site has been tracking student loan refinance lenders for years.
During that time, loan origination fees and prepayment fees have almost entirely been eliminated from the marketplace. Lenders that tried to add an origination fee were criticized and borrowers steered clear. At present, loan origination fees are only used by some lenders for in-school loans.
Despite the positive changes for consumers, there is always the danger that new lenders could enter the scene and charge an origination fee. As a result, borrowers should carefully read any contract for a fee that could be hidden in the fine print.
Debt-To-Income (DTI) Ratio Concerns
The Debt-To-Income Ratio, or DTI, is a number that creditors look at when evaluating applications. The DTI compares an applicants monthly income against their monthly debt.
Generally speaking, student loan refinancing is a useful tool for improving a borrower’s DTI. However, in certain cases, a refinance can hurt the borrowers DTI. Negative changes to DTI could make it harder to qualify for a mortgage or auto loan in the future.
There are two main potentially negative consequences that borrowers should consider:
Increased Monthly Payments – Many borrowers choose to refinance their student loans on a 5-year repayment plan. The 5-year loan terms have the lowest rates available. The danger in this route is that the minimum monthly payment needs to be quite large in order to pay the debt in full. Thus, the short repayment plan means much lower interest rates, but higher monthly payments. While this is a great way to eliminate debt, it can make qualifying for a mortgage harder. Borrowers who may be considering buying a home in the future should focus on longer repayment lengths in order to keep their minimum monthly payment lower.
Cosigner Concerns – Some borrowers choose to have a cosigner on their refinance loan in order to help their chances of approval. Cosigners who were not on the original loans will have new debt added to their credit report. Even if the primary borrowers is making payments on time, cosigners can still face negative consequences for being on the loan because cosigned loans are often included in DTI calculations by creditors. If the cosigner was on the original loan, and the new monthly payment is lower, the refinance can help the cosigner. If the cosigner was on the original loan and not included on the new loan, the refinance is a great way to get a cosigner release.
Tax Deductions Issues
One way the government helps with student loan repayment is in the form of a tax deduction.
The student loan tax deduction applies only to interest paid. Payments towards loan principal are not included in the deduction. Borrowers are able to deduct up to $2,500 of student loan interest payments. (Note: A $2,500 deduction does not mean $2,500 less on taxes, it means the government taxes the borrower as if they earned $2,500 less that year.)
Due to the limitations of the student loan interest tax deduction, it isn’t a huge break for most borrowers, but it can still be worth several hundred dollars each April.
Refinancing student debt, can affect this deduction in two ways:
Refinance with a Personal Loan – Nearly all student loan refinance companies refinance student loans with a new loan that qualifies for the deduction. The one notable exception is First Republic. First Republic student loan refinancing utilizes a personal loan instead of a student loan and as a result interest on the new refinanced loan is not deductible.
Less Spent on Interest – Put this is the category of technically true, but not really a “concern” to be worried about. The idea behind refinancing is to save money on interest. Spending less on interest means potentially getting less of a deduction. That being said, avoiding a refinance for the purpose of keeping interest rates high in order to maximize a deduction would be a huge mistake.
Due to the nature of the deduction, the value of saving money on student loan interest will always exceed any potential deduction of student loan interest from taxes.
Consumers looking to refinance student loans are much more savvy than most in-school student loan borrowers. Repaying student debt tends to make people more careful with future student loan contracts. As a result, lenders seem to realize they can’t get away nonsense fees and expenses.
Refinancing remains a huge financial decision due to the large amounts of money changing hands. Borrowers should carefully consider all of the potential consequences before actually refinancing their loans.
Borrowers that decide that refinancing is right for their situation should invest an hour or two in order to shop around to find the best interest rates possible. Each lender uses a different formula for evaluating applications and determining the rate the lender will offer.
The entire purpose of the process is to save money on interest and the only way to know which lender has the best rate is to check…
|Pros:||SoFi is the only lender who will help a borrower find a job, and they routinely have the lowest rates offered.||LendKey works with a large network of smaller credit unions and banks. As a result, many applicants get the best offer from LendKey.||Splash has the best new customer bonus right now, and they have unique 8 and 12 year repayment terms.||Because ELFI is backed by a bank rather than investors, ELFI rates tend to stay low and fluctuate less than others.|
|Cons:||SoFi has grown into a large company offering mortgages, personal loans, and investment services. They no longer focus entirely on student loan refinancing.||Going the LendKey route does require working with a local bank or credit union. For many, this is a plus, but it is an extra step.||Splash is a newer lender and the longest length loan is 15 years instead of the industry standard 20.||ELFI is one of the newest lenders in the marketplace. As a result we have limited head to head information.|