Student loan refinancing can be a dramatic change to your student loans. Many borrowers fear that a student loan refinance could mean the end of the student loan interest tax deduction.
Refinancing usually means a new lender, new interest rate, and new monthly payment.
Fortunately for borrowers, in most cases, refinancing will not impact the student loan interest deduction. However, a small group of borrowers will receive a slightly smaller deduction or lose the student loan interest deduction completely. These borrowers make up a small minority.
Student Loan Refinancing and the Interest Deduction Basics
The IRS has detailed rules regarding the student loan interest deduction, but for the most part, if a student loan was borrowed to pay for most college costs, borrowers can get the deduction.
A Note about the Student Loan Interest Deduction: Compared to most other tax breaks, the student loan interest deduction is pretty lousy.
Only the portion of a student loan payment that goes towards interest is deductible at tax time. The IRS caps the deduction for borrowers above certain income levels.
Suppose a borrower makes $500 per month student loan payments and pays $100 per month in interest. In this case, the majority of the payment does not qualify for a tax break. Only the portion of the payment applied to interest qualifies for a deduction. Here, the borrower would potentially be able to deduct $1,200 for a year’s worth of payments ($100 times 12 months).
This borrower wouldn’t save $1,200 on their taxes. Instead, they would be taxed as though they earned $1,200 less. In short, thousands of dollars worth of payments during the year might be worth a few hundred dollars at tax time.
Student loan refinancing doesn’t change the rules, and in most cases, it doesn’t change a borrower’s eligibility for the discount. Like the original lender that issued the loan, a student loan refinance company will send out a 1098-E for borrowers that documents the interest spending for a given tax year.
The Times When a Student Loan Refinance Changes the Tax Deduction
There are two primary circumstances where refinancing a student loan can potentially impact the tax break.
Lower Interest Payments – By refinancing at a lower interest rate, a borrower spends less on interest and may end up with a smaller deduction. Whether or not the deduction is changed depends upon the borrower’s income level and amount of debt. However, borrowers shouldn’t change their refinance plans because of this concern. Choosing to spend extra money on interest to save a little bit at tax time wouldn’t make sense.
Personal Loan Refinance – A traditional student loan refinance pays off old student loans and replaces the debt with a new student loan. However, a lender might pay off the existing student loans and replace them with a personal loan. As a personal loan, the debt would not be eligible for the student loan interest deduction. At present, we are only aware of one lender that uses this approach. That lender is First Republic Bank.
Lenders Eligible for the Interest Deduction
As long as the lender is advertising student loan refinancing, the loan will almost certainly be eligible for the tax break. Lenders have a huge incentive to have the debt be considered a student loan instead of a personal loan due to bankruptcy rules. Borrowers concerned that their loan won’t qualify should look at the loan contract to verify that it is a student loan and not a personal loan.
Many lenders, including companies like Lending Tree and Lending Club, offer personal loans. These loans are not eligible for the student loan interest deduction.
Some companies, such as SoFi and Earnest, offer both personal loans and student loan refinancing. However, these lenders clearly identify which loans are personal loans and which loans are student loan refinancing.
The student loan refinance lenders from our rankings are all be eligible for that tax deduction.
Finally, borrowers should know that interest rates on a student loan refinance are almost always significantly lower than for a personal loan. Rarely will it ever make sense to seek out a personal loan instead of a traditional student loan refinance.
Does Federal Direct Consolidation Change the Interest Deduction?
In most matters dealing with student debt strategy, federal loans and private loans behave differently.
However, in this instance, federal direct consolidation works similarly to student loan refinancing.
Borrowers who use federal direct consolidation for their fed loans will still receive a 1098-E, and they will still be able to claim the student loan interest deduction each year.
Other Hidden Costs of Refinancing
Borrowers investigating the student loan interest deduction implications on refinancing should also examine the other hidden costs of refinancing.
Even though the interest deduction is mostly unchanged, there are other significant consequences, especially for those considering refinancing a federal government student loan.