Travis from Student Loan Planner is with us today to let us know 5 points in life when student loan refinancing may be your best option.
(Photo courtesy of Al Emmert)
Like many people in the U.S., you might have student loan debt from your time in college. After graduating with the degree of your choice, it’s time to repay your loans and it can be overwhelming.
I can’t blame you for feeling this way — I’ve been in your shoes. It’s not easy to know the right approach to paying off your student loans, and you might not even know you have options beyond a standard repayment plan.
If you’re like Jon and Heather, who have a plan to pay off student loan debt quickly, that’s great! They have an amazing story and were able to knock out tons of student loan debt in a short amount of time.
But not everyone can be that laser-focused. Other people are in a position where it makes perfect sense to refinance their student loans instead. Here’s what you need to know about student loan refinancing and how to know if it makes sense for you.
What is student loan refinancing?
Student loan refinancing is the process of obtaining a new student loan to replace your old loans. Your new lender pays off your old loans and a new loan is created. Your new loan has a new interest rate and repayment terms. Normally, student loan refinancing is done through private lenders, banks or credit unions.
People usually look into refinancing to try and lower their interest rate or escape a bad federal loan servicer.
5 times when student loan refinancing is your best option
Refinancing student loans isn’t always the best option for everyone. There are times when it is a smart choice which largely depends on your circumstances and financial needs. These five instances are when it might make sense to refinance your student loans.
1. When your debt-to-income ratio is below 1.5 to 1
A debt-to-income (DTI) ratio is a number that lenders use to assess whether you can manage new debt on top of your existing payments. DTI ratio is calculated by dividing your total monthly debt payments by your gross monthly income. This is how much money you make before tax and other deductions. If your DTI is below 1.5, you would likely pay off your student loans before taking advantage of forgiveness options.
For example, if your monthly recurring expenses total $12,500 and your gross monthly income is $10,000, you have a DTI of 1.25 to 1. In these instances, it makes more sense to lower your interest rate through refinancing and pay off your loans quickly.
If your monthly expenses totaled $12,500, but your gross monthly income is $7,500, then your DTI is 1.67 to 1. It might make more sense to try for student loan forgiveness. You could get your payments lowered on an income-driven repayment (IDR) plan.
Take Action: Do you know your DTI ratio? If not, take time to calculate it so you can compare your debt against your income. This leads to more clarity on your repayment options.
2. When you have an emergency fund to cover three months of expenses
Do you have an emergency fund? It’s one of the building blocks of saving and investing. An emergency fund protects you from unexpected expenses that pop up. You will want to save up at least three months worth of expenses before pursuing student loan refinancing. This allows you to aggressively pay down your debt and wipe out your student loans.
What if your car breaks down or you end up in the hospital? An emergency fund helps you cover those bills and still afford your student loan payments. Focusing on aggressively repaying student loan debt won’t help, if you aren’t prepared for an emergency and need to use credit cards. You are just trading one debt for another.
Having an emergency fund is a good idea no matter what financial goals you have. You never know when an unexpected life event will occur, draining your savings and creating a financial hardship.
Take Action: If you don’t have an emergency fund, find ways to save money every month until you’ve built an adequate fund.
3. When there is an interest savings of at least 0.5%
One of the main reasons to refinance your student loans is to secure a lower interest rate than your existing loans. Say you graduated from medical school with $58,000 in Direct Unsubsidized Loans with a 6.6% interest rate. It’s possible, with excellent credit, to lower your rate by a few percentage points knocking thousands of dollars in interest charges off your loans.
If you don’t have excellent credit and can only lower your interest rate to 6.2%, for example, refinancing isn’t going to make a big difference. At this point, it makes more sense to keep the repayment protections that come with federal loans, like:
- Deferment
- Forbearance
- Income-driven repayment plans
By keeping your federal loans, you could pursue Public Service Loan Forgiveness (PSLF) if you are eligible, or Income-based repayment (IBR) loan forgiveness after 20 to 25 years of payments.
Take Action: If you don’t have good enough credit to get lower interest rates, work toward improving your credit by making on-time payments to start.
4. When you are confident you won’t qualify for loan forgiveness
If you don’t plan on pursuing federal loan forgiveness programs, refinancing could be the right repayment option for you. This choice might come up, for example, if you have no desire to work in the public sector long enough to make the required 10 years of qualifying payments for PSLF.
Depending on your career type, you could generate more than enough income in the private sector to negate the need for loan forgiveness.
IBR loan forgiveness takes 20 to 25 years, depending on the specific repayment plan you are under. If you don’t want to keep your debt around that long, refinance your student loans and work to pay them off quickly.
Take Action: Take time to look over the details regarding PSLF. If you are pursuing forgiveness, it’s important to know the rules before you get started.
5. When you won’t need forbearance protections
Forbearance is the ability to delay your monthly payments temporarily. You don’t have to make payments while your loans are in forbearance. The government allows you to pause payments for a year at a time, up to three years total.
One thing to remember with forbearance is that during this period, your loans continue to accrue interest. Your interest eventually capitalizes, which means it gets added to your principal balance costing you more money over time.
If you have money saved up in an emergency fund, as mentioned earlier, you might not need to rely on forbearance. In this situation, refinancing your student loan debt and lowering your interest rate is a more important goal.
Take Action: Take a survey of your finances and determine if you’re stable enough to give up this valuable protection.
Refinancing your student loans is a great repayment option that can save you thousands of dollars. Some people I’ve helped have cut tens of thousands of dollars off of their student loan debt. Taking the time to go through all of your repayment options and making the right choice for your situation is a gamechanger.
Travis Hornsby founded Student Loan Planner after helping his physician wife navigate ridiculously complex student loan repayment decisions. To date, he’s consulted on over $400 million in student debt personally, more than anyone else in the country. He is a Chartered Financial Analyst and brings his background as a former bond trader trading billions of dollars.
He brings that same intensity to analyzing the best repayment paths for graduate degree professionals with six figures of student debt. He’s helped over 1,700 clients save over $80 million dollars on their student loans, and he’s been featured in U.S. News, Business Insider, Forbes, Huffington Post, Rolling Stone, ChooseFi, Bigger Pockets Money, and more.
