Student loans can be a heavy and confusing burden to carry after graduation. “Thank god the private refinancing market exists now,” says Joshua Holt, who runs The Big Law Investor blog and refinanced his $190,000 law school debt with Earnest to lighten the load.
Earnest, along with competitors CommonBond, Darien Rowayton Bank (DRB), SoFi, and Citizens Bank, have collectively refinanced more than $5 billion in loans since 2012. Like Holt, many who have been able to tap into the burgeoning private refinancing market view it as one of the best innovations in the personal finance sector, saving tens of thousands of dollars. With competition and the current low interest rate environment, now is an opportune time for millennials to consider refinancing. But it’s not the right choice for everyone.
The decision is complex—it depends on individual circumstances and many unknowns. While it is hard to capture all of the nuances in a succinct guide, one can simplify the decision-making process by focusing on two broad dimensions: (1) Evaluate your potential savings and (2) Contemplate your risk tolerance or the degree of certainty about your current situation.
Evaluate Your Potential Savings:
Will I qualify for refinancing?
All five of the major refinancing companies advertise large potential savings. In reality, however, those savings are not open to just anyone. Companies cherry-pick borrowers “who have excellent income and excellent credit history. It’s doctors and lawyers. Those are the people who are benefiting from the refinancing programs,” Adam Minsky, a Boston lawyer specializing in student loan issues, told the Boston Globe.
Each company determines whether it is willing to refinance your loan and, if so, at what interest rate, using a proprietary method that may include your credit history, your outstanding loan balance, and your current income and occupation. Many require credit scores close to or above 700 as well as a relatively low debt-to-income ratio to qualify; requirements are even more stringent for the lowest-advertised interest rates. But new entrants, competitive pressure, and refined risk algorithms have loosened restrictions and will hopefully make refinancing a more widely-feasible option. As competition intensifies, some companies are differentiating themselves by taking a more holistic look at a candidate’s finances. For example, when Holt refinanced with Earnest, he gave them access to his financial accounts so the company could look at his deposits and conduct a more thorough analysis to determine the real risk. (Holt felt comfortable sharing his information, but changed his passwords after Earnest had completed its review.)
If I qualify, what is the best interest rate I can get?
Aside from maintaining rock-solid credit, the best way to ensure you are getting the lowest interest rate is to shop around. You shouldn’t be afraid of harming your credit score by applying with several lenders at the same time. Typically when you apply for credit (like an auto loan, home mortgage, or private student loan), lenders will pull your credit history, known as a “hard pull” (you don’t want too many hard pulls on your credit as each can lower your credit score). However, the credit bureaus have logic built into their scoring formulas that can discern when consumers are shopping around for a loan and avoid penalizing them. Simply put, they treat multiple inquires resulting from the act of shopping for one loan as a single inquiry. Therefore, if you apply with several lenders, do so in a concentrated time period (within 14 days ideally). Doing so won’t hurt your credit, and it will give you a range of options.
You should also check with your employer and any professional associations you’re a member of, as some have formed partnerships with loan refinancing companies. These partnerships may make it easier to be approved with less-than-pristine credit or even allow you to obtain a better interest rate. For example, last year the American Dental Association (ADA) announced an exclusive partnership with DRB to provide its members “with lower rates that translate into greater peace of mind and substantial savings at a pivotal point in their careers.” By refinancing with DRB through the ADA, members would have their interest rate reduced by an additional 0.25 percent.
Don’t forget to also factor in various incentives that companies may offer. Most will reduce your rate by 0.25 percent if you allow them to automatically deduct the monthly payment from your bank account. Not only will this save you money, but automation will also reduce the likelihood that you will forget to pay your bill and hurt your credit score. Some companies offer other discounts. For example, Citizens Bank offers a loyalty discount of 0.25 percent if you have a qualifying account at the institution.
Conversely, watch out for fees and restrictions that may reduce your savings. Most of the newer entrants are extremely consumer friendly; they neither charge fees (e.g., an application fee) nor prepayment penalties (i.e., a monetary penalty charged for paying off your loan quicker than the term of the loan). I hope it stays this way as this is in the best interest of graduates; however, if interest rates start to rise and business starts to tighten, I wouldn’t be surprised to see some companies introduce some of these fees to maintain their profit margins while still being able to advertise lower interest rates. Bottom-line, even if you are refinancing now, take at least a cursory glance, but if you are refinancing in the future, take a closer look.
Will economic conditions change and how much would changes affect my potential savings?
The protracted recovery from the 2008 recession has caused the Federal Reserve to keep the U.S. economy in a very low interest-rate environment. The lowest rates companies offer graduates refinancing their loans are variable and are pegged to a market benchmark rate, usually the 1 or 3 month London Interbank Offered Rate commonly known as LIBOR. In other words, they have also been quite low, but can fluctuate over time. Those with variable rates may start to see their monthly payments increase if the benchmark rate increases, thereby reducing potential savings.
Historically, rates have not increased quickly. Guidance from Fed Chairwoman Janet Yellen after the September 2016 central bank meeting indicates that this will soon change as “the median projection for the federal funds rate rises only gradually to 1.1% at the end of next year, 1.9% at the end of 2018, and 2.6% by the end of 2019.” While the Federal Reserve has recently delayed raising rates, Yellen’s guidance means there is higher probability that rates will start to rise next year.
If you qualify for a loan with one of the lowest refinancing rates, you will have a bigger buffer against rate increases. For example, if you had a fixed 6.8% federal rate and refinanced with Common Bond at their lowest rate on a 10-year loan (3.04% as of October 9, 2016) you would be saving money even if benchmark rates went up (and stayed up) by 3.5%. However, if your credit wasn’t pristine and you got a higher rate, your buffer would inherently be smaller. The highest rate Common Bond offers on a 10-year loan – 5.4% – means that if benchmark rates rose by just 1.5%, you would be paying a higher interest rate than if you had stayed with the fixed federal rate of 6.8%.
One alternative is go with a fixed interest rate instead of a variable rate. Fixed rates are usually higher than variable rates. Choosing a fixed rate may reduce your potential savings, but it also means you won’t have to worry about the rate increasing over the life of the loan. For a practical way of thinking whether to refinance with a fixed or variable rate, see Holt’s excellent post on the topic, which argues that taking on a fixed interest rate loan is akin to taking out insurance against rising rates (and usually isn’t worth it). It’s important to consider the pros and cons of fixed versus variable interest rates when deciding whether to refinance, and if so, what kind of loan to take out.
How much could I save?
Once you determine if you qualify and what the best interest rate available to you is, it’s time for the fun part: Calculating your potential savings.
Reducing your interest rate allows you to free up cash each month by lowering your monthly payment. Since you are accruing less interest, you need to pay less each month to pay off the loan in the same time period. Alternatively, if you’re comfortable with the amount of your current monthly payment, you can save even more by keeping the same payment and shortening the length of your loan. Since you are accruing less interest, if you keep paying the same each month, you will pay off the loan faster.
Let’s take a look at an actual example to help illustrate these two scenarios. (I like NerdWallet’s refinance calculator and the corresponding guide by Teddy Nykiel if you’re looking for help.)
Current Loan: Suppose you are about to start repaying a graduate school loan of $50,000. Your loans have a 6.8% interest rate and you have a standard 10-year repayment term.
Refinanced Loan Option 1: Suppose you are able to refinance your loan at half of the original interest rate, 3.4%. You decide to keep the 10 year repayment plan.
Refinanced Loan Option 2: You refinance your loan at half the original rate, 3.4%, but decide to continue paying the same amount each month, accelerating the 10 year repayment plan.