Should You Refinance Your Federal Student Loans Into A Private Loan?

We read recently that another bank is offering to refinance federal student loans into private loans. It’s currently offering these loans starting as low as 4.75% for borrowers that have a good credit score, long-term employment and that have a checking account at the bank. It is also offering variable rate loans as low as 2.31%,

How this compares with federal PLUS loans

These rates are dramatically lower than rates that parents got when they took out federal PLUS loans as they have interest rates ranging from 6.41% and 8.5%. Other federal loans generally have high rates and don’t offer many alternatives for getting them reduced.

Federal Direct Consolidation Loans

One option available to people with multiple student loans is to consolidate them into a federal Direct Consolidation Loan. However, the interest rates on these loans are the weighted average of the loans being consolidated rounded up to the nearest 1/8th of one percent. What this means is that if you were to opt for one of these loans your new interest rate would be higher than the loan with the lowest interest rate you’re currently paying but lower than the one with the highest interest rate. In other words, you might see a reduction in your interest rate but it probably wouldn’t be very dramatic vs. that loan at 4.75%.

Other options

Other banks are beginning to offer similar refinancing loans. For example, Discover Financial Services, Social Finance (SoFi) and Commonbond all offer to refinance federal loans. Social Finance is an especially interesting alternative. It’s currently offering fixed rate loans starting at 3.63% and variable rate loans as low as 2.66% APR (with AutoPay).

However, to qualify for one of these loans you must have graduated from one of SoFi’s 500+ colleges and universities and your loan would come not from SoFi but from the school’s alumni. In addition, you must be currently employed, a US citizen or permanent resident, have graduated from one of SoFi’s member schools and have a good credit and employment history.

Should you stay or should you go?

Should you refinance those student loans by converting them into a private loan or stay with what you’ve got?

Unfortunately, this is not an easy question to answer, as there are pros and cons to both of these options. Of course, the biggest pro to refinancing those student loans is if you could get a dramatically lower interest rate. As an example of what this could mean let’s suppose you owe $30,000 for 10 years at 8%. In this case your monthly payment would be about $363. If you were to refinance that federal debt to a loan at 4.75% your monthly payment would fall to about $314 — a savings of $49 a month or $588 a year. In addition, you would have a fixed interest rate for a fixed term, a fixed monthly payment and just one payment a month.

Would this be enough to tempt you to refinance?

The reasons to stay

As you have seen in the example given above, you probably need to have a lot of student debt at a very high interest rate to make refinancing an attractive option. But even if you do, it’s important to understand what you would be giving up – or those benefits that come with federal student loans.

Repayment options

Once you refinance federal student loans into a private loan you will have just one repayment program, which is to make the same payment every month for 10 years or whatever is the term of your loan. If you were to run into a serious financial problem you wouldn’t be able to change your repayment program to fit your new circumstances. In comparison, federal student loans have six repayment programs not counting the federal Direct Consolidation Loans mentioned above. While none of these will get your interest rates cut they could get your monthly payments reduced.

Graduated Repayment

One of the most popular repayment options available with federal student loans is Graduated Repayment. This can be especially helpful if you are just starting out in your career as your payments would start low and then gradually increase every two years. By the time you hit year six (or two increases), you’d most likely be earning more so your payments would still be affordable.

Income-driven repayment

In addition to Graduated Repayment, the US Department of Education (ED) offers three “income-driven” repayment programs where your monthly payments are tied to your income and family size. The programs are Pay As You Earn, Income-Based, and Income-Contingent.

Pay As You Earn

You may have read about this program last summer when Pres. Obama signed an executive order making about 5 million more people eligible. Prior to this order, only those who were newer borrowers were eligible for Pay As You Earn. However, starting next year borrowers who took out loans before October 2007 or stopped borrowing by October 2011 are also now eligible.

What’s the big deal about Pay As You Earn? It’s that this program would cap your monthly payments at 10% of your household income that exceeds 150% of the federal poverty guideline based on the size of your family. An example of how this works is if your monthly adjusted gross income were $4280, you would subtract 150% of the poverty line ($1480) yielding discretionary income of $2800. Multiply this by 10% and your monthly payment would be $280.

Income-Based Repayment

A second income-driven repayment program is Income-Based. If you don’t qualify for Pay As You Earn, you might qualify for this program, which would cap your monthly payment at 15% of your discretionary income. Take the example given above and multiply that $2800 by 15% and the monthly payment would be $420.

Income-Contingent Repayment

If you don’t qualify for either Pay As Your Earn or Income-Based Repayment, there is Income-Contingent Repayment. The biggest plus of this plan is there are no initial income eligibility requirements. If you have any eligible federal student loan, you could switch to this plan. Like Pay As you Earn and Income-Based, your payments would be based on your family size and income but will likely be higher than those under Pay As You Earn or Income-Based repayment. What would your monthly payment be under Income-Contingent Repayment? It gets a bit complicated so the easiest answer is to calculate what it might be.

Changing repayment programs

Another important reason why you might want to stay with your federal student loans is that you always have the option to change your repayment plan. If you are on 10-Year Standard Repayment and are having a tough time making your payments, you could switch to either Graduated Repayment or one of the Income-driven repayment programs. Or maybe you’re on Graduated Repayment but have found that you are now eligible for Pay As You Earn. You could easily make the switch and see your monthly payments cut substantially. The

Before you make your final decision

There are several things you should do before you decide whether or not to refinance your federal student loans. First, be sure to go to the Department of Education website and familiarize yourself with all the various repayment options available. Second, call your loan servicing company to discuss this with it. When you do this you will be assigned a counselor that will discuss all of the options with you and help you determine if there is a program that would be better than the one you currently have. Be sure to understand all of their options including interest rates and terms. Then with this information in hand it should be much easier to decide whether to stay or go – to a private debt consolidation loan.