The Federal Reserve recently announced plans to wind down pandemic-related economic support, and it signaled an openness to raise interest rates in 2022. For years, interest rates have been at a record low, keeping borrowing costs low for many consumer products and services. However, several Federal Reserve officials suggested last week that federal rates could increase by nearly two points by the end of 2023. This could have ripple effects across the financial sector.
With a limited time window remaining for historically low-interest rates, should student loan borrowers consider refinancing their loans? Borrowers should factor in several considerations.
Potential benefits of refinancing
The main reason borrowers refinance their student loans is to get a lower interest rate. A lower rate can reduce the borrower’s monthly payment, which can dramatically lower the total amount that the borrower would pay over time.
To illustrate, a borrower with $60,000 in student loans with an interest rate of 8% would have payments of $500 per month on a 20-year term; that borrower would pay, in total, approximately $120,000 over the course of the repayment period — twice her original loan balance. In contrast, if the borrower refinances that loan at a 5% rate on a 20-year term, the payments would be only $395 per month, and she would pay under $95,000 in total payments – a comparative savings of over $25,000.
Given that interest rates will likely be rising over the next couple of years (and possibly beyond), borrowers looking for the lowest possible rate may want to consider refinancing soon.
There are sometimes other benefits of refinancing, as well. Since refinancing involves taking out a new loan that replaces the old loan, the new loan may have better terms and conditions, such as more opportunities for deferments or forbearances or more flexible repayment options.
In addition, refinancing can function as an effective cosigner release mechanism. If the original loan was cosigned, and the borrower refinances that loan in the borrower’s name only, the cosigner on the underlying loan is effectively released once that underlying loan is paid in full by the lender doing the refinancing.
Potential drawbacks to refinancing
But refinancing student loans can also have serious drawbacks. This is particularly true when borrowers refinance federal student loans into private loans.
Congress sets federal student loan interest rates, so the only way to change those rates would be to refinance via a private loan program. Since private student loans cannot be refinanced or consolidated back into a federal loan, refinancing is a one-way ticket out of the federal student loan system. This means that by refinancing, borrowers would be forever closing the door on critical federal student loan programs like Public Service Loan Forgiveness and Income-Driven Repayment.
Since Congress and a president generally have more authority to tinker with the federal student loan system than with private loans, this also means that leaving the federal loan system means walking away from unexpected relief programs as well. That can include the ongoing national Covid-related pause on federal student loan payments and interest and the new Limited PSLF Waiver that expanded access to a major student loan forgiveness program for public service workers.
Federal student loans also generally have consumer protections that are much stronger than most private student loans. Federal student loans can be discharged upon the borrower’s death or disability (and federal officials are in the process of making the federal disability discharge program even more borrower-friendly); in general, a statute-based disability discharge program is usually stronger than anything offered solely through a private loan agreement. Federal student loans can also be brought out of default through statutory default resolution programs; most private student loans cannot.
Borrowers who are thinking about refinancing should consider several important factors:
- Are you refinancing private loans or federal loans? Take stock of what you might be giving up by refinancing a federal loan via a private loan program and whether it’s really worth a reduction in the loan’s interest rate.
- Fixed interest rate, or variable? While an initially lower variable rate loan might be attractive, borrowers should consider locking in their interest rate from the beginning through a fixed-rate loan. A fixed interest rate is beneficial not just for predictability and stability but also because there’s only one direction that most interest rates will be going in the coming years – and that’s up. So a variable rate loan carries some risk.
- Are there origination fees? Loan products that add on fees to a refinanced loan could offset some of the savings a borrower may be hoping to achieve by refinancing in the first place.
- What are the terms and conditions of the refinancing loan? Are there multiple repayment plan options available? What happens if you lose your job or have an unexpected financial emergency and cannot afford your payments? What happens to the loan if you die or become disabled?
- Are there ways of mitigating risks associated with the refinancing loan? For example, can you take out additional life or disability insurance if refinancing means losing out on more robust discharge protections? Can you establish a dedicated emergency fund to cover payments for six months or 12 months in the event that you experience hardship but have little repayment flexibility?
Refinancing student loans may be the right decision for some borrowers, but not all. Take stock of your situation, including what you might be getting or giving up. And consult with a professional before making a big decision. Once you sign off on a new loan, there may be no going back.