When to Refinance Your Federal Student Loans
Refinancing federal loans is an irreversible decision so you want to be sure before you move forward. (At the time of this post in November 2020, the potential for major changes to student loan forgiveness is possible given the current political climate. Any student loan forgiveness will only apply to federal loans and any of those loans that are refinanced will lose that benefit forever. With that in mind, it’s a good idea to postpone any refinancing of federal student loans until that question is more clearly answered, likely not before Spring 2021.)
As we learned there are two types of student loans: federal and private. (See my post What’s Your Student Loan Type for more info on how to figure out what you have). And although federal loans have many benefits, they can have high interest rates and those rates never change over the life of the loan. So if you had the unfortunate luck of graduating with high interest federal loans (over 5%) and you’re pursuing a full repayment strategy, refinancing those federal loans could shave thousands of dollars and years off your repayment journey. But refinancing results in the loss of all those wonderful federal protections, so tread carefully.
What is refinancing?
Refinancing refers to the process of taking out a new loan (with new terms) to pay off an existing loan. So in the case of federal student loans, when you refinance, you’re taking out a new private loan and using that new loan to pay off your existing federal and/or private loan(s). The federal loans are paid off entirely and those accounts are closed on your credit report and in the records on studentaid.gov. And now you just need to pay according to the terms of your new private loan.
What’s the big deal?
Refinancing a federal loan converts it into a private loan and that’s an irreversible decision. You cannot refinance a private loan into a federal loan, so once you make the decision you’re stuck in the private loan universe and the hope is that you’re prepared for those consequences.
Federal loans provide a number of protections for borrowers, especially when those borrowers have trouble making their monthly payments. Here are some of the most important federal loan benefits:
Income Driven Repayment Plans - certain federal loans qualify for income driven repayment programs such as PAYE, REPAYE, and Income Based Repayment. These payment plans base your monthly payment on your actual income, which can be very helpful for graduates who may be in a lower income position or are just having trouble making payments (this even happens to Biglaw attorneys depending on how much they borrowed!). And after 20-25 years the remaining balance of your loans will be forgiven. See my post on Student Loan Forgiveness Plans & Pitfalls for more info on how this works.
Deferment & Forbearance - many federal loans are eligible for deferment during certain circumstances. Deferment allows you to temporarily stop making payments and you can qualify for this relief if you’re still in school, participating in the Peace Corps, have income below a certain percentage of the poverty line based on your location and family size, active duty, and other reasons. Deferment may stop interest from accruing on your loans, but that doesn’t apply for every type of loan. Forbearance also allows you to temporarily stop making payments under certain circumstances but interest will accrue so it’s not ideal for any long-term solution. When deciding between deferment and forbearance, deferment is often preferred if you can qualify.
Forgiveness - Federal loans are the only ones that qualify for those nice forgiveness programs more fully discussed in my post Forgiveness Plans & Pitfalls. Once you refinance to private loans, forgiveness is no longer an option.
Cancellation upon death - Federal student loans do not survive your death. Upon your passing, they are cancelled rather than having to be paid out from your estate or by your heirs, assuming you did not have any guarantors or co-signors on your loans. The same is not true of private loans.
In refinancing your federal loans you’ll be giving up all these benefits. It’s not the end of the world, but it’s a big decision and you’ll want to consider it thoroughly.
So when is it a good idea to refinance your federal loans?
Notwithstanding the wonderful array of benefits that go along with federal student loans, sometimes the best path forward is to just refinance them. Federal loans often carry much higher interest rates than one could find on the private market, and when you’re dealing with hundreds of thousands of dollars in student loans, that interest adds up.
So here are some situations where refinancing may make sense:
Your income > total debt - if your annual income exceeds the total amount of debt you have, then you may be a good candidate for a full repayment plan. If you’re pursuing an aggressive repayment plan (no forgiveness) and are trying to get your loans paid off as quickly as possible, then refinancing will both shorten the timeline and lower the total cost.
You have income security - if your job and salary are secure (meaning you’re not in danger of losing your job or having a reduction in your income) then as long as you refinance to a loan with a monthly payment you can afford, then you should be able to make those payments over the full term of the loan. If your income is not secure, moving from the federal loan universe to the private loan universe may not be a good idea because you’d actually want access to those federal loan payment relief programs.
Your lifestyle allows for large monthly payments - if you are not balancing other large financial obligations (high cost of living area, daycare expenses, large mortgage payment, supporting other family, etc.) then you may have the room in your living budget to make those aggressive monthly loan payments over the full term of the new loan.
You have excellent credit - you’ll need to qualify for private loans so the type of interest rates and payment terms you may get will depend largely on your credit history and current income. If you have poor credit, you likely won’t qualify for the lowest rates and may not save much over the life of your loan — a savings that may not warrant giving up those federal loan benefits.
You want to be done with your loans ASAP - for many graduates their student loans are a source of immense stress. If that’s your situation, then no matter what the numbers say, you’ll want to consider a plan that gets them out of your life as quickly as possible. When working with clients, I always examine both the financial and emotional aspects of debt since we all think of it differently. Those non-numerical considerations should also be taken into account when deciding whether to refinance.
So what’s the verdict?
Is refinancing your federal student loans the right move for you? You now have some points to consider to help you make the decision, but these things are not simple and they’re not easy to maneuver alone.
If you’d like some help figuring out the best path for your student loan repayment journey, schedule a free consult and we’ll start figuring it out together.
