The burden of student loan debt can be a major obstacle in life, whether it’s delaying getting married, buying your first home, pursuing an entrepreneurial endeavor, saving for retirement, or simply being free to enjoy life, be it dining out or exploring an intriguing destination.
Refinancing your federal student loans could be the solution, but be sure to understand all the facts before you act.
How Does Student Loan Refinancing Work?
For starters, by switching to a private lender, you could refinance a high-interest student loan with a loan that has a lower interest rate. That means more of your payments go toward the principal, so you can get out of debt faster.
A loan with a lower rate also reduces your monthly payment. So, if you continue to pay as much each month as you are now, you’d pay off your debt sooner. That means your total cost would be less in the long run, because you’d be paying less interest all along the way.
If you choose to pay the lower monthly rate, that would free up more cash for yourself right away. In the long term, however, it would still take the same amount of time to get out of debt.
Another way to lower your monthly payment would be to select a longer-term loan when refinancing. You’d pay more interest over time, but you’d have more cash available now.
Do You Qualify for Refinancing?
Lenders will consider several factors when you apply to refinance a student loan. Here are some of the major things they will look for:
Are you employed?
Having a job shows an ability to make the payments on your refinanced loan.
Do you have positive cash flow?
In other words, how easily can you pay off your loan? Lenders will look at your debt-to-income ratio. To calculate your DTI, add up your total monthly debt payments (such as a car loan, mortgage and credit card payments) and divide that sum by your gross monthly income (before tax and other income deductions). The lower it is, the better. A DTI around 40% means there’s stress on your finances. A debt-to-income ratio around 20% shows a greater ability to keep up with debt payments.
How good is your credit score?
It should be at least in the high 600s. If not, try applying with a co-signer who has stronger credit. Your co-signer will be responsible for payments if you can’t make them. The co-signer’s credit report will reflect your refinanced loan, so if you miss any payments, it will impact their credit score.
Another thing to consider: When refinancing a federal loan to a private loan, you would not be able to use government programs for income-driven repayment and loan forgiveness.
How Much Can You Save, Become Debt-Free Faster, or Both?
Locking in a lower interest rate for your loan could save you a bundle. Here’s an example:
Let’s say that you owe $30,000 on your loan and your interest rate is 6%, with 10 years remaining on your loan term. You’ll pay a total amount of $9,967 in interest. If you qualified for a 4% interest rate, though, your total interest over 10 years would be $6,448. You would save $3,519.
At the same time, a lower interest rate would also lower your monthly payment. Using this same example, your monthly payment would drop from $333 to $304 and you’d save $29 a month.
On the other hand, you could get out of debt faster and pay dramatically less interest overall by grabbing a lower interest rate and also shortening the term of the loan. This is a great strategy if you can swing a higher monthly payment.
Using the same example again, if you refinanced a $30,000 loan at a 4% interest rate instead of 6% and paid it off in 10 years instead of 15 years, you’d pay a total of $6,448 in interest instead of $15,568. You’d save $9,120 over the course of the loan and be free of student debt five years faster. This is a great option if, in this case, you could handle a $51 increase in your monthly payment, which would go from $253 to $304.
To be sure, refinancing can be an easy way to save money. Taking advantage of this strategy yields benefits, whether it’s enjoying more of what life has to offer now, saving for meeting future financial goals, or a bit of both. By taking a simple look at what’s involved, you can see if refinancing works for you.