Refinancing vs. Consolidating Student Loans

Your Student Debt Options

In today’s world, it’s common for new graduates to carry student debt. Typically student loans are extended at the start of their education with fixed terms. But recent (and not-so-recent) graduates should be aware that there are two options available to adjust the terms of their loan repayment, refinancing and consolidating. Which of these two options is right for you depends on your purpose, whether it is to decrease the amount paid each month, pay off the entire loan faster, or procure a more favorable interest rate. Let’s start with Consolidation…

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Consolidating Your Student Loan

Consolidating your student loans is solely available as a government program, for students with multiple federal education loans. The program allows you to bundle your loans together and sets the interest rate at the average of the previous interest rates you were paying on each loan. However, the new interest rate is not a simple average; rather, it is a “weighted” average of the prior rates. So if one of your original loans is much larger than another, the interest rate on the first loan will count for a greater amount when the new, consolidated interest rate is calculated.

The result of this calculation is that, provided you choose a loan term (number of years until payoff) that is the same as it would have been prior to consolidation, you end up paying roughly the same monthly amount post-consolidation. The benefit is making one payment rather than multiple payments each month. The way you lower your overall monthly payment is by choosing a longer consolidated loan term, which actually increases the amount of interest (and thus the total amount of money you have to pay) over time. You could also choose a shorter loan term, increasing your monthly payment but lowering the amount of money paid over time.

Federal Loan A

Federal Loan B

Sum of Original Loans

Consolidated Loan

Loan Balance

$5,000

$5,000

$10,000

$10,000

Interest Rate

3%

6%

4.5%

4.5%

Monthly Payment

$48.28

$55.51

$103.79

$103.64

Total Interest Paid

$793.65

$1,661.24

$2,454.89

$2,436.56

The key point to take away from all of this is that “consolidating” your student loans does not actually mean changing the original interest rate that was set for each original loan. You will end up paying that rate for the proportional amount of the new “consolidated” loan, and the only adjustments to the overall dollar amount paid by the loan payoff date will occur if you change the amount of time (and thus the amount of interest) it takes you to pay off the loan.

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Refinancing Your Student Loan

If you’re working with a private lender, you will be “refinancing” rather than “consolidating” your loans. When you refinance, you may be able to change the actual interest rate on your loan(s) in addition to the period of time until payoff. You can refinance a single loan or multiple loans, and if you’re doing the latter, there is often an option to “bundle” the loans together just as you would if you were consolidating, though it depends on the lender.

Refinancing works best if you have gained employment in the private sector since graduating, and your financial situation has improved, whether due to salary or another factor that improved your credit score. This is because private lenders offer lower interest rates to borrowers who can provide a steady work history that demonstrates consistent cash flow, and who have a higher credit score. When you graduate, you may not have much work history to speak of beyond college internships. And you may not have built a significant credit history, especially if you didn’t use a credit card while in school. Now that you’re in the workforce, if you’ve been making regular payments on your loans at the original interest rate, your credit history has been building whether or not you also took out another type of loan (like a mortgage or car loan) or opened one or more credit cards. If you’ve also done the latter and likewise been making regular payments, your credit history will be even more fleshed out. Whatever your situation checking your credit score is a good idea when understanding your over all financial picture. Keep in mind most lenders require a minimum credit score of 600-650 in order to qualify for student loan refinancing.

When you refinance your student loans, you are actually taking out a brand new loan. This new loan is used to pay off the old ones. Going forward, you have one payment (for the “bundle” of loans now rolled into one) that is ideally accruing interest at a lower rate than the old loans were previously. If your credit score has risen substantially due to any of the above factors, the interest rate that a private lender is willing to grant you may end up saving you a lot of money in the long run.

 

Original Loan

New Loan

Savings Over Time

Loan Balance

$5,000

$5,000

 

Interest Rate

6%

3%

 

Total Interest Paid

$800

$391

$409

Monthly Payment

$97

$90

$7/month

If you decide to refinance, make sure you understand whether you are refinancing into a fixed-rate or variable-rate loan. On a fixed-rate loan, the interest rate that is set at the beginning of the loan term is the rate you will continue to pay until the loan is paid off. On a variable-rate loan, the rate set at the beginning can change over time. Some lenders provide for a change every 3 months, others set the rate for longer periods of time. The big risk you’re taking if you sign up to refinance into a variable rate loan is that interest rates will increase, sometimes substantially, and you’ll end up paying more overall. However, if you plan to pay off your loan in a much shorter time than that for which the term is set (but can’t just pay it off right away) then you could choose a variable rate loan, which usually comes with a lower initial interest rate, if you’re confident that your plans for a quick payoff won’t change.

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Which Is Right For Me?

It seems like a straightforward choice, but it really depends on your unique situation. In two particular cases, it’s best to consolidate your federal student loans.

  1. Low Original Interest Rate
    The interest rate on a federal loan (historically, anywhere from 3-8%) is not always lower than the interest rate on a private loan. But if it is, it’s best to leave the loan alone or consolidate a few low-interest-rate federal loans into one to simplify your monthly payment.
  2. Public Sector Employment
    There is a special program for students who take out federal loans and go on to work in the public sector, whether at a government institution or a not-for-profit organization. This is the oft-touted “loan forgiveness” program, where by making 120 payments on time (10 years at 12 months each) the government forgives the remainder of your loan amount, in recognition of the contributions you are making to the country through your public service. The protection offered for public sector employees by this program is not available through private lenders. There are other specialized programs, like the income-based repayment programs and programs for teachers or healthcare workers serving low-income populations, that only benefit a small portion of the workforce but are likewise good options that would be terminated if borrowers refinanced with a private lender.

Let’s go back to our original example of loan consolidation. If you consolidate but keep a loan term of 10 years, you will pay $2,436.56 in interest. If you extend your loan term to 15 years, you will pay less each month on the consolidated loan, but pay $3,769.83 in interest. While this doesn’t make sense for most people, it might be a good option for some borrowers participating in a loan forgiveness program, because you only need to make 10 years of payments before the balance of the loan is forgiven. In this example, after 10 years you would have paid $9,180 and the remainder of the loan could be forgiven, whereas if you took a 10-year term you would have paid $12,436.56.

 

Sum of Original Loans

Consolidated Loan – 10 Year Term

Consolidated Loan – 15 Year Term

Loan Balance

$10,000

$10,000

$10,000

Interest Rate

4.5%

4.5%

4.5%

Monthly Payment

$103.79

$103.64

$76.50

Total Interest Paid

$2,454.89

$2,436.56

$3,769.83

Total Amount Paid at 10 Years

$12,454.89

$12,436.56

$9,180**

For private sector employees who are earning above a certain threshold amount, refinancing could be the better option. Refinancing can also be a good choice for borrowers who are several years out of school and focused on lowering their personal debt-to-income ratio in order to qualify for a loan on a big purchase, like a home or a car. It really does depend on your unique circumstance.

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Final Thoughts

The most important consideration when choosing whether to consolidate, refinance, or leave your loans alone is to look at the overall financial picture of your life as it is right now, and see whether changing your loan terms will provide the best short-term and/or long-term benefit to meet your goals.

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June 4, 2019

Alyssa Cotler

Alyssa specializes in creating content and website copy for law and accounting firms and nonprofit organizations. She has an undergraduate degree in history and a J. D. from Columbia Law School.

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