In May 2016, U.S. college graduates owed an average of $37,172, a 78% increase from 2006 figures, according to data compiled by student loan expert Mark Kantrowitz.
Fortunately, college grads with good credit and a steady full-time income are excellent candidates to refinance their loans—that is, pay off existing loans with new loans, typically at lower interest rates. Per calculations based on those who refinanced their loans via Credible, a multilender marketplace, from April 2015 through September 2016, borrowers saved an average of about $19,000.
What Benefits Will Be Lost When Refinancing Federal Loans?
When considering whether to refinance your federal student loans, be aware of opportunities that will no longer be available to you: public service loan forgiveness, income-driven repayment options, deferment, and forbearance. Deferment, forbearance, and special plans will most likely cost you substantially more money in total and should be absolute last resorts.
Deferment is putting loan payments on pause. Your subsidized loans will not accrue interest, but your unsubsidized ones will. Forbearance is reducing or pausing the amount of your loan payments, but interest typically continues to accrue regardless of whether the loan is subsidized or unsubsidized.
Payment plans offered by government-issued student loans allow you to reduce your monthly payment dues, including income-driven repayment plans such as Pay As You Earn (PAYE). There are also extended plans, in which your payments are lower (both fixed and graduated as options) but over a longer term, and graduated plans, in which payments are lower at first and increase over time. There are seven total repayment options alternative to the standard repayment plan, which will be your financially wisest option.
Public service loan forgiveness is really only available to those who work in public service, such as in government and nonprofit organizations. It forgives the remaining amount of your loan balance after working full-time for a qualifying employer for making monthly payments for ten years. You’ll probably be done paying off your loans by that time.
Take a look at the Federal Student Aid office’s pages on repayment options and their Public Service Loan Forgiveness Program for more details.
Refinance Loan Shopping – Soft versus Hard Credit Pulls
Generally, lenders perform a soft credit pull to determine initial rates, but if you choose to apply for a loan, a hard credit pull is performed. While soft credit pulls don’t affect your credit, hard credit pulls may decrease your credit score by a few points and appear on your credit report for two years.
However, credit bureaus factor in whether you’re shopping around for a single loan using scoring formulas that consolidate several loan inquiries performed during a certain time frame into one. With the FICO scoring model, used by 90% of top lenders, your credit score can be lowered by up to five points, and all hard pulls within a 45-day window are rolled into one. FICO’s competitor, VantageScore, is less forgiving. It only consolidates loan inquiries within a 14-day window, and your credit may be lowered by 10–20 points, according to Heather Battison, a TransUnion vice president.
Therefore, you should try to apply to several lenders within a two-week time frame to minimize the impact to your credit score.
What Are Variable and Fixed Rates?
As you’ve probably guessed, variable (or “floating”) interest rates fluctuate, while fixed rates remain the same throughout the life of the loan repayment term.
If you originally took out federal loans, you may not be familiar with fixed rate; they have been at fixed rates only since July 2006. CommonBond additionally offers a “hybrid” loan, ranging from 3.82% to 6.26% interest rate with autopay, which provides a 10-year fixed-rate loan for the first five years, which switched to a variable-rate loan for the remainder of the term.
How Are Variable Rates Determined?
Fixed rates are straightforward, but understanding a variable interest rate requires some digging.
Variable (or “adjustable”) interest rates are determined based on two factors: a benchmark index/market rate, serving as a reference for interest rates on student loans (as well as mortgages, credit cards, etc.), and a margin (or “spread”), a fixed interest amount added to the index rate, chosen by lenders based on one’s creditworthiness. The sum of the margin and benchmark index interest rate is called the “fully indexed rate.” These terms are the same used in the context of mortgages, so they may come in handy down the line.
The majority of variable interest rates for student loans are based on 1-month LIBOR, the London Interbank Offered Rate, which is what large banks charge one another in interest to lend money over a one-month period. Since it’s a rate that changes every month, the interest rate of loans that use it change monthly as well. Below is a graph of recent fluctuations in 1-month LIBOR assembled by the Federal Reserve of St. Louis. You can view further historical levels on their webpage<, in addition to the Wall Street Journal’s.
Incidentally, one-month LIBOR tends to closely trail the Federal Reserve’s benchmark interest rate, the effective federal funds rate, a weighted average of the rates at which banks charge to lend to each other an on overnight basis. To elucidate, commercial banks (those that provide services to the public) are required to maintain an amount of money in the Federal Reserve by Central Banks (also referred to as reserve banks or monetary authority), national banks that regulate commercial banks and money supply. In order to meet reserve requirements, banks with a surplus of money in the Federal Reserve lend it to those that need it at an overnight interest rate, the federal funds rate. Although 1-month LIBOR isn’t controlled by the effective federal funds rate, it’s a good indicator of what it will be during the ensuing month. Below is a graph from Earnest’s blog illustrating how closely synced they have been since the mid-1990s.
Should I Choose a Variable- or Fixed-Rate Loan?
When deciding whether to go with a variable-rate loan, you should check whether the lender you’re considering has a cap on it, i.e., the maximum interest the lender will charge on it regardless of how much the index rate increases.
Variable interest rate minimums are lower, and may be a better option for those who are confident they can pay their loans off quickly, since there is less opportunity for them to fluctuate. Fixed rates, which have a higher interest rate due to lenders taking on the burden of risk of rates rising, may be a better choice for someone who is unsure as to whether they will be able to pay off their loans reasonably quickly or are uncomfortable with taking a gamble.
Personally, I would avoid a variable-rate refinance loan offer unless it were significantly lower in percentage to my current fixed interest rate. Perhaps at least 2%, but it’s arbitrary since there’s no knowing how it will change.
Each of the loan servicers I looked into offer a discount of 0.25% to those who authorize them to automatically deduct payments from a bank account each month.
Additionally, Citizens Bank checking and/or savings account holders are eligible for an extra 0.25% discount. However, this option is only available to those residing in states where branches are found, Connecticut, Delaware, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Vermont.
Term Length and Monthly Payment Amounts
Shorter repayment terms will yield not only lower interest rates, but the less time it takes you to pay off your principal (and interest that is capitalized), the lower your total cost will be. The quicker you pay off your balance, the less time the interest will have to accrue.
Choosing a Lender
There are many student loan refinancing companies out there—refer to my overview of several major student loan refinancing lenders to get a clearer picture of your options. You can check your rates without harming your credit using the student loan marketplace Credible.