The Student Loan Loophole

Michael Lux Blog, Student Loans 1 Comment

To most borrowers a student loan is a monthly headache.  To lenders, it is part of an important contract and a key source of income.  Under this contract, the lender loans money out up front, and in return the borrower pays back all of that money plus interest.  This contract lays out all of the rules between the borrower and the lender, including the interest rate that the borrower must pay.

At growing trend among borrowers is to take full advantage of the fact that these contracts specify that there is no pre-payment penalty.  In other words, the sooner the loan is paid off, the sooner the contract ends and the sooner the interest payments stop.  Borrowers take full advantage of this “loophole” by refinancing their loans with another company.  The original lender immediately stops profiting from the loan, the borrower gets a much lower interest rate, and the new lender gets a new customer.  The process saves the average borrower over $10,000.

How does it work?

To understand how this “loophole” works, you first need to understand how interest rates work.  Interest rates are not just some made up number.  Instead, interest rates are carefully calculated by lenders based upon how much risk is associated with the loan.

If a lender issues 100 student loans, they know that it is highly unlikely that all 100 borrowers will pay back the loan in full.  Some might not graduate, while others may not find good paying jobs.  As a result, they increase the interest rates to make sure that they still make a profit even if some people fail to pay back the loan.  As a general rule, the riskier the loan, the higher the interest rates need to be.  This is the reason that unsecured debt, such as credit card or payday loans have high interest rates while less risky debt, such as a home mortgage, comes with a lower interest rate.

The “loophole” comes into play with student loans because the borrower risk changes significantly in a very short period of time.  When borrowers take out their first student loans, they are often unemployed or working a minimum wage job.  These borrowers typically have nothing more than a high school diploma, and a very short credit history.  From a risk based perspective, this is a pretty dangerous loan.  The riskiness of the loan is the reason that student loan interest rates of 8% or higher are very common.

Compare the risk of a recent high school grad to a college grad who is now a working professional.  Now you have someone who has a much better income, education, and credit history.  This borrower has so little risk that lenders are willing to offer student loan interest rates below 3%.  Some companies, such as SoFi or Laurel Road, will actually pay cash up front to attract these borrowers to their services.  At the time borrowers choose to refinance or consolidate their student loans, they are probably a much safer bet than they were when the loan was originally issued.  As a result they can lock in lower interest rates and save significantly over the life of the loan.

What is “the catch”?

Taking advantage of the consolidation “loophole” is not entirely without risk.  Ending your relationship with your original lender is great, but it requires creating a new relationship with a new lender.  That means a new contract.

In many cases, especially with private lenders, the terms are often similar.  However, some of the old student loan contracts may have great terms that new lenders may not offer.  This is especially true in the case of federal student loans.  These loans have programs like income based repayment and public service student loan forgiveness.  The question for borrowers to consider is, are the federal perks worth the higher interest rates?

Bottom Line

Tearing up one contract and starting a new one may not be for everyone, but it is a great way to leverage your increased income and credit score into lower payments.  With interest rates at or near record lows and companies lining up to refinance, now is a great time to investigate.

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Bryan Bowling
Bryan Bowling

This is very dangerous advice. Leaving government backed lenders for private means you also lose out on government repayment options that are very forgiving, like income-contingent plans, or the service forgiveness options that allow you to not pay anything back after 10 years.

Please, please do just a little more homework people!