Student Loan Plan: Refinance Just High-Interest Loans or All Loans?

Michael Lux Blog, Consolidation, Lower Payments, Student Loan Plan, Student Loans 0 Comments

In this edition of the Student Loan Plan, we discuss the refinancing and consolidation strategy for Amy, who has $42,000 in private student loans between two companies.  If you want tips for dealing with your student loans, contact us.

Amy writes:

I have two private loans; one from Discover with a balance of 14,000 and a monthly payment of $120 (3% interest) and one from Wells Fargo of 28,000, a monthly payment of $240 (7% interest). Is combining the two worth it? What would my new loan look like?

The Plan

For starters, you are smart to be looking into refinancing your private loans.  The analysis is trickier with federal loans, but for private student loans it is almost always a good idea to take advantage of your employment status and credit score.  The average college grad is much less of a credit risk than they were at the time they borrowed the loans, so it is very common to be able to find lower interest rates through refinancing.

This situation is complicated by the fact that your loan with discover has an excellent interest of 3%.  It isn’t clear from Amy’s email whether that 3% is fixed rate or variable, so we will take a look at both.

Based upon the limited information available, there are basically two routes for Amy to explore.  Route one would be combining the two loans together through consolidation.  Route two would be to just refinance the high interest loan.

Combining the loans… aka consolidation

We might be getting a bit greedy here, but it is actually possible that Amy can improve the interest rates on both of her loans by consolidation.  Granted, beating 3% is asking a lot, but according to our latest student loan refinancing chart, there are currently six companies that could potentially beat that 3%.  It is also worth noting that most of the time the lowest advertised rate is a variable rate loan.  If you are lucky enough to have a fixed rate loan at 3%, it will be almost impossible to beat.

Should Amy chose to combine the loans into a consolidated loan, there are some advantages beyond the reduced interest rate.  For starters, it means she now deals with just one lender instead of two.  That means half the headaches and half the bills to remember.

Another potential advantage of having a larger consolidated loan could be a lower minimum monthly payment and a longer repayment period.  This is because lenders will typically offer more time to pay off a larger balance.  Even if you can pay more, a lower minimum affords flexibility in months where the budget is tight.  The lower minimum also can help your debt to income ratio should applying for a mortgage be in your future.  Lower minimum payments means more borrowing power.

The disadvantage to the longer repayment term and lower minimum payment is that it often comes with a higher interest rate.  Lenders typically offer the best rates to people who will be paying the loan off in five years or less.  As repayment length gets longer, rates go up.  The only way to know what your rate would be at your desired repayment length is to talk directly to some of the student loan consolidation companies.

Refinancing just the high interest loan

The reality of Amy’s situation is that the 3% loan will be hard to beat.  If she can’t find a better deal elsewhere, she has the option of refinancing the high interest loan and keeping the low-interest loan where it is.

Not only would going this route be smart from an interest rate perspective, but it also affords Amy some flexibility.  One of the few joys of dealing with student loan debt is the satisfaction that comes from completely eliminating a loan.  It means one less payment each month, one less lender to deal with, and one step closer to freedom from student loans.  It also frees up some cash each month to attack your other loans.

The advantage of separate smaller loans goes beyond psychology.  It also makes manipulating your finances for purposes of getting a mortgage easier.  As we said in the previous section, lower minimum payments means more buying power.  However, one big loan represents one big obstacle to pay off.  The mortgage advantage depends heavily upon your timeline and how much money you are able to put towards your student loans each month.

As an example, suppose Amy consolidates the two loans into one and her new monthly payment is $300.  Currently, she is paying at total of $360 per month ($120 for Loan A and $240 for Loan B).  For the sake of discussion, let’s assume that keeping the loans separate results in a lower interest rate, but the monthly payment stays the same (in reality it could go up or down, depending upon repayment length).  Based on these numbers, if Amy is applying for a mortgage in the near future, she is better off consolidating due to the lower monthly payment of $300.  However, if Amy won’t be purchasing a home for five years, the numbers may change.  If she is able to entirely pay off Loan A in that time, her monthly student loan bill is now only $240… yet if she combined the debts, here minimum will still be the $300.

Bottom Line

The best option for anyone in Amy’s situation depends upon a number of different circumstances.  From a simple math perspective, you just go with the lowest interest rate option, whether it be combining the loans or just refinancing the high interest loan.

Things get more complicated if you factor in your other financial goals.  Whether it be buying a house, financing a car, or retiring.  As we showed in the example of a mortgage, you need to look at the relationship between length of the loan and interest rate as well as the timeline for your goals and your ability to pay each month.

Often there is not answer that is clearly right or wrong.  The key is to understand the factors relevant to your decision and to put together a workable plan for your goals.