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The Coronavirus Aid, Relief and Economic Security (CARES) Act offers relief for millions of student loan borrowers, providing suspended payments through September 2020.
But not all student loans were eligible for the economic stimulus package, including 12% of federal loans and all private loans. And some who were eligible may still need relief after the suspension period ends.
If you need help with your student loan payments, refinancing may be on your mind. While it's possible to reduce your monthly payment—and possibly even your interest rate—through refinancing, there are some potential drawbacks that could do more harm than good.
How Student Loan Refinancing Works
Student loan refinancing involves replacing one or more existing student loans with a new one offered by a private lender. You can refinance federal loans, private loans and even both together if you want.
There are several private lenders that offer student loan refinancing options, and most of them allow you to get prequalified before you apply. This process allows you to easily shop around and compare rate offers from multiple lenders to ensure you get the best one.
To give you an idea of the potential benefit, let's say you have $20,000 in student loans and an average interest rate of 5.75%. With a 10-year repayment plan, your monthly payment would be $220, and you'd pay $6,345 in interest over the life of your loans.
If you were to refinance those loans at a 4.5% interest rate, it would reduce your monthly payment to $207, which is only a $13 decrease. But over 10 years, you'd save $1,472 in interest.
Depending on how much debt you have and the interest rate you qualify for, you could get even more savings through refinancing.
The Benefits of Student Loan Refinancing
There are several ways that student loan refinancing can help you with your debt. The more student debt you have and the higher your current interest rates, the more you stand to benefit.
- Lower interest rates: If you qualify, you could score a lower interest rate than what you're currently paying. This will not only reduce how much you pay each month but also lower your total interest charges over the life of your new loan.
- Payment flexibility: Student loan refinancing lenders offer flexible repayment terms, which can range from five to 20 years. If your budget is tight, you could get an even lower monthly payment by extending your repayment term. With the previous example, for instance, if you were to keep the same interest rate but extend your repayment term to 20 years, your monthly payment would be $140 instead of $220. Just keep in mind that your total interest charges would more than double.
- Choice of lender: Federal student loan borrowers don't get a choice in who their loan servicer is when they get approved for new loans. And if you have private loans, your options may have been somewhat limited as a college student. But with refinancing, you have the chance to choose your new lender based on their interest rates and other features, such as unemployment protection, forbearance options and more.
If you're considering refinancing, think about these potential benefits and how they might help you with your current financial situation.
The Drawbacks of Student Loan Refinancing
While there are some clear benefits to refinancing your student loans, there are also some potential problems that could make your situation more challenging.
- No guarantee: Refinancing isn't available to everyone. The average FICO® Score☉ and annual income for approved borrowers are 774 and $98,156, respectively, according to Purefy, a student loan refinancing lender. If you can't get approved on your own, you may be able to apply with a cosigner. But that's not always feasible.
- Loss of federal benefits: If you have federal student loans, you have access to certain benefits that private loans don't offer. That includes student loan forgiveness programs and income-driven repayment plans. Also, if you're struggling financially, the federal government typically offers more generous forbearance options than private lenders.
- Possible variable interest rates: If your goal is to lower your interest rate, make sure you understand which type of rate you're getting. Variable interest rates generally start off lower than fixed rates, but they fluctuate over time with the current market rates, and you may end up with a higher interest rate than the one you have now. Fixed rates may be higher than variable rates, but they provide the certainty of a rate that won't change for the life of your loan.
Depending on your situation, these drawbacks may not be deal breakers. But it's crucial that you take the time to understand how refinancing could potentially hurt your financial situation even more instead of making it better.
Consider an Income-Driven Repayment Plan
If you have federal student loans that aren't covered under the CARES Act or you think you'll need more relief after the CARES Act suspension period ends, consider applying for an income-driven repayment plan instead of refinancing.
The U.S. Department of Education's income-driven repayment plans reduce your monthly payment to between 10% and 20% of your discretionary income. They also extend your repayment term to 20 or 25 years, with the chance of forgiveness of your remaining balance once that period ends.
Taking on an income-driven repayment plan will mean paying more interest over time, and any loan forgiveness you receive will be considered taxable income. But if you need relief now, it could provide more relief than refinancing because payments are based on your actual income.
Also, choosing an income-driven repayment plan doesn't rule out your option to refinance at a later time. On the flip side, you can't convert a private refinance loan back into a federal loan.
Check Your Credit Before Considering Refinancing
Because your credit score plays an important role in your odds of getting approved for refinancing and your interest rate, it's important to check your credit score to see where you stand.
Also, check your credit report to see if there are any areas you can address before you apply. For example, you may have high credit card balances, past-due payments or even inaccurate information that could be hurting your credit score.
Working to improve your credit can take some time, but the effort can pay off if it helps you qualify for a lower interest rate and better overall terms than what you have right now.