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Why is it Risky to Refinance Federal Loans into a Private Loan?

Refinancing student loans is a great way to get lower interest rates, but it is a risky move for borrowers with federal student loans.

Written By: Michael P. Lux, Esq.

Published:

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Why is it Risky to Refinance Federal Loans into a Private Loan?

Refinancing student loans is a great way to get lower interest rates, but it is a risky move for borrowers with federal student loans.

Written By: Michael P. Lux, Esq.

Published:

Affiliate Disclosure and Integrity Pledge

The low interest rates and large signup bonuses from refinancing are well-publicized. Refinance lenders spend a lot of money advertising their products.

While refinancing can undoubtedly be a good option for some borrowers, it comes with major risks for federal student loan borrowers.

Refinancing a Federal Loan into a Private Loan

When you refinance, you are essentially borrowing money from a new lender to pay off an old loan. The money never passes through your hands, but the end result is that your old loan is paid in full and replaced with new debt from a new lender.

The typical advantage of this process is either lower monthly payments or a lowered interest rate.

However, because the federal government doesn’t refinance student loans, borrowers must use a private lender to refinance their government loans. Thus, borrowers erase the federal loans and federal benefits and replace them with a private loan and new terms.

Risks from Passing on Student Loan Forgiveness and Income-Driven Repayment

Refinancing means giving up on all of the federal student loan perks. This includes borrower protections like Income-Driven Repayment and Student Loan Forgiveness.

Public Service Loan Forgiveness is the forgiveness program that gets the most attention from borrowers and the media, but there is a long list of government loan forgiveness programs. Not all borrowers qualify for forgiveness, but refinancing permanently erases the possibility of forgiveness. This is a much more significant risk for some borrowers than others.

Income-Driven repayment is a valuable federal loan perk, even if you choose a different repayment plan. The value of an IDR plan is the safety net that it provides. If you ever lose your job or take a big pay cut, IDR options ensure payments stay affordable. Borrowers facing long-term unemployment can qualify for $0 monthly payments for as long as necessary.

Other Risks to a Private Refinance of Government Loans

The tricky part about accessing the risk of refinancing your federal loans is that it’s impossible to know for sure what you are giving up.

The current federal repayment plans and forgiveness programs may seem lousy, but future options might be more appealing.

For example, some borrowers refinanced their federal loans in the summer of 2019. They likely made this decision to save money on interest while in repayment. The Covid-19 payment and interest freeze wasn’t on anybody’s radar in the summer of 2019. Unfortuantely for those who refinanced at that time, refinancing ended up costing more in interest.

That said, the odds of forgiveness for all look bleak for the foreseeable future. The decision to bet on future government help is also pretty risky.

Sherpa Thought: The decision to refinance or not refinance requires balancing some unknowns. You don’t know what your future holds, and you don’t know what the future holds for federal loans.

The important thing is to make a sound decision based upon the information available at the time. Gather as much information as you can and weigh your options as they apply to your circumstances.

Who Should Refinance Federal Loans?

This is the $89,512 question. (Feel free to insert your loan balance.)

Let’s take care of the obvious answers first. If you have private loans, you can refinance those without much concern. If you are currently benefiting from the federal interest freeze or pursuing loan forgiveness, don’t refinance your federal loans.

Now for the more complicated choices. I’d say two requirements must be met to make refinancing a federal loan make sense.

  1. Refinancing must be worth it. When I say “worth it” I mean that the benefit of refinancing needs to be considerable. Don’t refinance to lower your intereest rate by .125%. Don’t refinance to lower your monthly payment by a few bucks. Refinancing federal loans only makes sense if there is an opportunity to save a significant amount of money.
  2. Repayment needs to be assured. If you have doubts about your ability to repay your student debt, don’t refinance your federal loans. If you earn a good living and think you will be able to find new work if your lose your job, refinancing becomes less risky.

Ultimately, you need to balance the pros and the cons. If the benefits of refinancing outweigh the risks, it could be a good option.

As of May 2022, the following lenders currently advertise the lowest refinance rates.

RankLenderLowest RateSherpa Review
T-1Earnest1.74%Earnest Review
T-1Splash Financial1.74%Splash Financial Review
T-1SoFi1.74%SoFi Review

Based upon the current market conditions, my favorite loan is the 20-year, fixed-rate loan. The interest rate is slightly higher than the 5-year loans, but the monthly payments will be much lower and far more flexible.

The following lenders currently have the lowest rates on 20-year, fixed-rate loans:

RankLenderLowest RateSherpa Review
1Splash Financial2.76%Splash Financial Review
2ELFI4.48%ELFI Review
3Citizen's Bank4.79%Citizen's Bank Review

Final Thought on Refinancing Federal Student Loans

I tend to be pretty risk-averse with my financial decisions. If you also like to play it safe, there is nothing wrong with paying a bit more in interest to keep your loans with the federal government.

About the Author

Student loan expert Michael Lux is a licensed attorney and the founder of The Student Loan Sherpa. He has helped borrowers navigate life with student debt since 2013.

Insight from Michael has been featured in US News & World Report, Forbes, The Wall Street Journal, and numerous other online and print publications.

Michael is available for speaking engagements and to respond to press inquiries.

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