When College Grads Should (And Shouldn’t) Refinance Student Loans

Editor’s Note: This article is a part of a series on investing advice for recent college graduates, drawing on expertise from financial professionals, university faculty and of course, InvestorPlace’s very own analysts and writers. Read more “Money Moves for Recent Grads” here and check out Top Grad Stocks 2021 for our best stocks to buy for new graduates.

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Student debt is a huge burden, said American adults in a 2011 Pew Research survey. 10 years later, that burden is nearly unbearable. The latest statistics show that the national student loan debt balance was worth $1.70 trillion in 2020, compared to $0.96 trillion in 2011.

As the national student loan balance grows, more and more college graduates are struggling to repay the debt. According to figures from Educationdata.org, about 37% of graduate degree holders aged 60 years and older have outstanding student loans.

College students who cannot pay for education out-of-pocket often rely on loans to get through school. Most students take out loans with the expectation that they’ll be able to repay them upon graduation.

But a combination of factors makes that easier said than done. Many young people take out loans without realizing the financial strain repaying them for years on end can cause. Stagnant wages and low-paying entry level jobs plus compounding interest often equals difficulty repaying the loans back quickly.

This is why so many students are left wondering how to pay off student debt in a fast, effective way that doesn’t leave them broke at the end of each month. And refinancing student loans is one such way.

What is Student Loan Refinancing?

Loan refinancing refers to securing new debt to repay outstanding loans. Often, the new loans come with lower interest rates and installments. Besides, refinancing shifts the repayment deadline further into the future, giving you a much-needed respite.

A downside of refinancing student loans may be increased total loan amount — lower monthly payments may mean a longer payment period and incurring more interest. But owing less monthly often gives those drowning in debt some room to breathe and get back on track.

With fixed-rate loans notching week after week of record low interest of late, new grads should seriously consider refinancing their student loans.

Refinancing Student Loans

If you think refinancing loans is the best option for you, here’s a step-by-step guide.

Step 1: Prequalify for Refinancing

In the actual sense, refinancing student loans entails a company buying your current loan obligation and extending you a new loan with different terms. That’s not going to happen if the company has doubts about your credibility.

So the first step involves finding out if the refinance lender can help you to refinance student loans. Different companies have different eligibility criteria. For instance, your credit score usually has to be pretty good. And your debt-to-income (DTI) ratio typically has to be less than 20%, preferably lower.

Step 2: Shortlist Appropriate Refinancers for Your Needs

Having established a rough idea about your eligibility for refinancing, it’s time to find the right lender. It is important to note that your situation determines the lender. For example, some lenders will only accept clients who have a college degree.

Step 3: Compare Rates And Repayment Terms Between Lenders

Ideally, you should end up with a list of lenders that accept clients in your situation. It helps to realize that each company charges different rates. Most lenders provide estimates based on the information you supply. Continue shopping until you find the lender with the lowest rates.

Step 4: Select the Best Option for You

Lenders tailor refinancing loans around either variable or fixed interest rates. Each structure impacts the total amount repayable differently. For example, variable rates are often lower at the beginning of repayment but then increase in the later stages. The problem here is that the structure makes for a longer repayment period, which increases the total loan amount.

It all comes down to how much you can afford per installment. If your income can support a fixed interest rate structure, all the better. This structure will shorten the repayment period, reducing the amount of interest you pay on top of your loan principle.

Step 5: Apply for Refinancing

A typical refinance loan application requires detailed personal financial information. The lender will want to know if you are financing another loan, a breakdown of your current income and so on. It is important to note that all the information you provide must be verifiable.

Qualifying for Student Loan Refinance

As with any other loan, the refinance loan requires borrowers to satisfy some preconditions. Although refinance lenders may use unique eligibility criteria, it is likely any lender will take a look at the following to determine your eligibility.

Your Credit Score

A credit score is a number that estimates your creditworthiness – basically, it measures your ability to repay debts. In the U.S., you are creditworthy if your credit score lies between 300 and 850. Most refinance lenders prefer a credit score of 650 and above.

Your Credit History

Lenders record all your loan-related transactions for later use. And lenders share those files among themselves. Lenders classify borrowers with unsound credit history as risky and they might reject their applications.

Your Income

No lender will accept your refinance loan application without proof of employment and income statements. The lenders need to know that you’ll have the cash to meet your obligations when they kick in.

Proof of College Degree or Graduation

Some lenders accept non-graduate clients but most won’t consider your application without a college degree. The assumption here is that college-educated borrowers have better chances at securing meaningful employment, and subsequently paying off their debts. A college degree is also solid evidence that the loan you wish to refinance actually went to paying for education expenses.

Credit Score

As we mentioned earlier, a credit score is a metric that estimates your creditworthiness. A low credit score will turn lenders away because you rank among risky clients.

But because lenders are in a business environment with tough competition, some of them are willing to take on higher risk. It means the acceptable credit score varies among lenders.

Fair Isaac Corporation (FICO) is a leading provider of credit score information to lenders in the United States. The company’s FICO Scores are a common reference point for the accepted range of credit scores needed to secure a loan.

A FICO Score below 580 is poor and above 800 is exceptional. You need to be in the ‘fair’ range – between 580 and 669 – to qualify for a loan from some lenders, although most lenders prefer FICO Scores above 669, which are ‘good’ or better.

When to Refinance Your Student Loans

There are times when refinancing your student loans may be a more viable or useful option than others.

Look for Low Interest Rates

The economic climate often cycles through recessions and upturns. As with all central banks worldwide, the Federal Reserve responds to economic cycles by cutting or raising the federal funds rate. The interest rate environment is inhospitable during a period of the economic boom because when the Fed raises the funds rate, private lenders follow suit to hedge their profits.

Therefore, the interest rate environment is best in a recession when interest rates are low, assuming that private lenders follow the Fed. You may see significant savings if you refinance student loans during this period because the new terms may include interest rates lower than the previous loan.

Your Finances are Solid(ish)

A higher salary lowers your debt-to-income ratio.  Lenders prefer borrowers with a low DTI because they are likely to pay off debts as agreed. You are likely to secure better terms when lenders perceive you as a reliable client.

You Have Private Student Loans

Federal student loans enjoy specific benefits that aren’t offered by private lenders. For instance, federal student loans are eligible for forgiveness or forbearance. The bad news is that you risk losing the benefits if you decide to refinance federal student loans with private lenders. As such, it is only sensible to refinance private student loans.

Will Refinancing Actually Help?

Most of the time, people refinance student loans mainly to reduce the total amount payable. Let’s say the interest rate environment is looking better, which makes it the right time to refinance. However, your credit score could be poorer than before, meaning you are likely to face harsher terms. In the long run, harsh terms will increase the total loan amount, which defeats the reason for refinancing in the first place. Weigh all the factors when you’re considering refinancing your student loans.

Refinancing vs. Consolidation

As earlier stated, refinancing student loans involves taking a new loan to pay for the outstanding one. The new loan has completely different terms and interest rates.

Conversely, student loan consolidation does not replace outstanding loans with a new one, but instead involves aggregating existing loans into a single one. The consolidated loan incurs a single fixed exchange rate, which is a weighted average of the previous loans’ interest rates.

The primary difference between student loan refinancing and consolidation is that refinancing can result in new terms, while they remain constant after consolidation. Consolidation only offers convenience when paying student loans, and maintains eligibility for federal loan forgiveness programs.

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