With student loan balances continuing to climb to astronomical levels, many borrowers are wondering the best way to simplify repayment and potentially save money. Two popular options are refinancing and consolidating student loans. However, the differences between these strategies aren’t always clear.
What is Refinancing Student Loans?
Refinancing student loans is the act of taking out a new private student loan to pay off existing federal and/or private student loans. The goal is to secure a lower interest rate to reduce interest costs over the life of the loan.
When refinancing, borrowers apply for a new loan from a private lender like a bank, credit union, or online lender. If approved, the lender pays off the current loans. The borrower then makes payments on the new single-refinanced loan.
Benefits of Refinancing
- Potentially lower interest rate – Rates are often lower than existing loan rates, allowing borrowers to save on total interest paid.
- Fixed or variable rate options – Borrowers can choose the type of rate that best fits their situation and preferences. Fixed rates offer stability, while variable rates can be lower if rates decrease.
- Streamlined repayment – Consolidating multiple loans into a single new loan simplifies repayment with just one monthly payment.
- Flexible repayment terms – Refinancing allows customizing the loan term to balance monthly costs versus overall interest costs. Longer terms lower monthly payments but involve paying more interest overall.
Drawbacks of Refinancing
- Loss of federal benefits – Federal loans come with benefits like income-driven repayment plans, loan forgiveness options, and the CARES Act interest waiver. Refinancing means giving up these benefits.
- Potential credit impact – A “hard” credit check is conducted during the refinancing application process, which could impact credit scores temporarily. Multiple applications also carry the risk of over-applying.
- Strict eligibility – To qualify for the best refinancing rates, borrowers typically need high credit scores and stable income enough to demonstrate repayment ability. Those with blemished credit may not qualify or get high rates.
- No deferment options – Private lenders typically do not offer deferment options like those that exist for federal loans when facing financial hardship like unemployment or returning to school.
What is Consolidating Student Loans?
Federal student loan consolidation involves combining multiple federal education loans into a single federal Direct Consolidation Loan. Similarly, the goal is to simplify repayment by streamlining it into one single payment.
A consolidation loan results in a weighted average interest rate rounded up to the nearest 1/8th of a percent based on the interest rates of the original loans. There is no credit check, and most borrowers who are not in default qualify. Loans can also be consolidated, whether in repayment or deferment status.
Benefits of Consolidating Federal Loans
- Single monthly payment – A consolidation loan streamlines multiple bills into one single payment amount each month.
- Potentially lower monthly payment – While interest rates remain the same, extending the loan term out up to 30 years through consolidation often lowers the monthly payment amount due to spreading costs over a longer period.
- Same loan benefits retained – Borrowers keep federal student loan benefits like income-driven repayment, deferment, forbearance, and potential forgiveness options on consolidated loans since it remains a federal loan.
- Grace period – There is a six month grace period after consolidation before repayment begins on the new loan, offering more time before payments resume if consolidating while in school or during the grace period.
Drawbacks of Consolidating Federal Loans
- Interest capitalizes – Outstanding interest on subsidized loans will capitalize and be added to the primary balance when consolidating, increasing the overall amount that starts accruing interest.
- Potentially higher overall costs – Extending the repayment term through consolidation keeps the lower monthly payment but also means making payments and paying interest for potentially decades longer, increasing overall costs versus keeping original terms.
- No lower rate – Interest rates remain the same as before, unlike refinancing, where lower rates are possible depending on credit factors and market conditions. Consolidation only combines rates; it does not lower them.
- Cannot separate spouse’s loans – If spouses consolidate their federal loans together, it may make their repayment status dependent on each other’s financial situations for income-driven plans. This level of entanglement can be problematic.
Key Factors to Consider
Both refinancing and consolidating student loans have advantages and disadvantages depending on individual borrower factors, financial goals, and risk tolerance. Here are some of the most important things to weigh when choosing:
- Credit score and income – Strong credit and steady income open doors to more competitive refinancing rates. Those with fair-good scores may find better options through consolidation.
- Federal benefits eligibility – If income-driven plans or forgiveness options like Public Service Loan Forgiveness could provide value, consolidation maintains eligibility versus refinancing.
- Repayment goals – Consolidation extends terms but keeps existing rates. Refinancing may achieve the goals of lowering monthly costs through possible rate decreases but involves higher cumulative interest costs.
- Risk tolerance – Refinancing exposes borrowers to risks of variable rates and losing federal protections if unable to repay. Consolidation retains safer federal loan terms but typically costs more overall due to interest capitalization and longer repayment.
- Loan types – Only federal loans can be consolidated. Mixes of federal/private or only private require refinancing the entire balance into a new private loan.
Weighing these core factors around individual financial circumstances, goals, and risk profiles will pinpoint whether refinancing or consolidation—or a hybrid strategy—makes the most sense for each unique situation. Let’s explore some additional considerations.
Interest Rates Matter Greatly
Comparing interest rates is of utmost importance when deciding between refinancing or consolidation. With rates hovering at all-time lows in late 2022 and projected to continue rising through 2023-2024, locking in a super-low rate could make refinancing very attractive right now.
Consider these key points on rates:
- Consolidation averages existing rates with no reduction. Refinancing aims to secure a new lower single rate.
- Rates of 5-7% are common for borrowers refinancing with top-tier credit into 5-10-year fixed terms in late 2022. Variable rates may start lower.
- Consolidating locks in the average of existing rates, which are often higher than current refinancing markets for most borrowers.
- Refinancing at even 0.5-1% lower than consolidation rates over a typical 10-year term could equate to thousands in interest savings.
- Yet variable rates pose a risk, so weigh the level of certainty preferred from fixed rates even at a slightly higher cost.
If able to qualify for competitive refinancing rates today versus consolidating and keeping old higher rates overall, the savings could be substantial in the long term. But act sooner than later before rates rise further.
Balancing Risks and Rewards
While refinancing offers potential savings from lower rates, it subjects borrowers to risks like losing federal protections and falling rates leading to variable payment increases. Consolidation retains safeguards but usually costs more over time. A hybrid approach may provide the best balance:
- Refinance private loans first for maximum savings while keeping federal loans eligible for programs.
- Refinance federal loans in stages, leaving some balance in original loans as a “backup” if refinancing fails or rates rise.
- Consider shorter 5-7 year fixed refinance terms versus 10+ years to refinance less interest cost while keeping payment flexibility.
- Shop lenders for variable rates with rate caps that limit how high payments can rise to add protection.
By spreading risk creatively across vehicles rather than full consolidation or refinancing, borrowers can minimize both costs and levels of uncertainty in repaying student debt obligations.
Timing Refinancing and Consolidation Wisely
The timing of refinancing or consolidating student loans matters substantially in weighing potential outcomes. Some key timing factors to keep in mind include:
- Interest rates – As discussed, lock in low rates now before further hikes, but anticipate potential future refinancing if rates drop again.
- Income changes – Wait until earning potential is high and stable for the best refinancing terms and ability to afford payments.
-IDR repayment plan – If pursuing PSLF, refinance minimally while in qualifying employment or not at all until closer to forgiveness.
- Family planning – Consolidate separately from a spouse if divorce could impact joint liability on an income-driven plan later.
- Job changes – Refinancing ties payments to current income, so consider timing around career transitions, unemployment, or returning to school.
Careful consideration of these timing elements relative to individual circumstances can optimize either staying put in current loans or activating consolidation/refinancing at just the right moment for maximum financial advantage.
Special Circumstances to Note
Several outlying circumstances warrant extra attention when weighing student loan consolidation or refinancing options:
- Defaulted loans – Federal loans in default cannot be consolidated until good standing is reestablished. Refinancing may require rehabilitation first. Special options exist to consolidate defaulted loans through the federal program.
- Bankruptcy – Student loans are generally not dischargeable through bankruptcy, though some limited paths exist under specific hardship conditions. Refinancing does not change this status.
- Disability discharge – Those with disabilities qualifying for a discharge of federal student loans would lose eligibility by refinancing. Consolidation maintains original loan terms.
- Married borrowers – Consolidating federal loans combines spouses’ debt legally and ties repayment statuses together. Refinancing separates loans but makes income-driven repayment unavailable.
- Ongoing education – Keep existing loan deferment benefits by consolidating federal loans if returning to further study. Refinancing requires deferment options from the new lender.
