If you’ve succeeded in scoring a refinance loan for your student loans, congratulations are in order. But before you sign your new loan contract, it’s worth considering whether student loan refinancing or consolidation with a federal direct consolidation loan is the better option for you.
After all, once you refinance with a private lender, you no longer have federal student loans. And while you can refinance as often as you can get approved for a loan, once you convert your loans from federal student loans to private student loans, there’s no going back.
So before you make that move, compare the benefits and drawbacks of each private loan offer versus what you could stand to gain or lose by going with federal student loan consolidation.
How to Compare Student Loan Consolidation and Refinancing Offers
The primary purpose of choosing refinancing over consolidation is to save the most money. But you still need to carefully compare the two options to decide which is right for you.
1. Compare Interest Rates
The purpose of refinancing is to lower your interest rate, which federal loan consolidation doesn’t do. But your federal consolidation loan could still come with a lower rate since federal student loan interest rates on direct loans have been historically low over the last decade, ranging between 3% to 5%.
That rate is tough to beat, even by the best student loan refinance companies. Plus, qualifying for the lowest rates is difficult without excellent credit.
If you don’t have a good credit score or your debt-to-income ratio is too high, applying with a co-signer can increase your odds of getting the best rates. But it’s risky since some lenders have no options for a co-signer release or make co-signers wait years before borrowers can remove them from the loan.
On the other hand, you don’t have to go through a credit check for a federal consolidation loan. Federal law determines the interest rates on federal student loans every year based on the yield of 10-year Treasury notes plus a fixed percentage. Whatever the interest rate was for the year you borrowed is the rate you keep for the life of the loan, even if you consolidate it.
Typically, student loan borrowers who seek to refinance are those with higher-interest-rate federal loans. Loans for graduate students versus undergraduates have higher interest rates. For example, for the 2021-22 academic year, the interest rate on federal direct loans for undergraduates is 3.73%. For grad students, it’s 5.28%.
The interest rate on PLUS loans is even higher. For both parent PLUS loans and grad PLUS loans, the interest rate for the 2021-22 academic year is 6.28%.
If you opt for federal consolidation, your new federal direct consolidation loan will calculate your interest rate as the weighted average of the interest rates of all your old loans to keep the interest roughly the same as what you were paying before. Thus, if you have any of these higher-interest-rate loans, consolidation could mean a higher interest rate than you’d get from a refinance.
Fortunately, it’s possible to compare before you commit. You can use an online calculator to see how federal loan consolidation could affect your current student loans. But remember that your interest rate will stay roughly the same as the average on all your current loans.
If you don’t already have refinance offers in hand to compare, use an online marketplace like Credible, which uses a soft credit inquiry to match you with prequalified offers. That way, you can see if you can do better with a private lender without affecting your credit score.
It’s also crucial to consider the impact of a variable interest rate versus a fixed interest rate.
Typically, you can start at a lower rate on a refinance loan if you opt for the variable interest rate. But variable rates fluctuate with market conditions, meaning they could go up. So even if you started with a lower rate than you previously had, you could end up with a higher interest rate.
That’s especially important now. According to CNBC, the Federal Reserve plans to increase interest rates within the next couple of years, so a variable-rate loan could end up costing you more in the long run.
But all federal student loans, including federal consolidation loans, are fixed-rate loans. So your interest rate won’t change. The only exception is if your loan servicer (the company that manages your payments on behalf of the ED) offers a 0.25% interest rate discount for making automatic payments, which is common among both federal loan servicers and the best lenders. So your rate could slightly decrease, but it will never increase.
As such, you may not want to choose a variable-interest-rate refinance loan over a fixed-rate federal consolidation loan if the difference in interest rates is low. But it could save you money to opt for a fixed-rate private loan over a fixed-rate federal loan if the private loan offers the lower rate.
2. Compare Repayment Term Lengths
Consolidation can lower your monthly payment, but it does so by extending the repayment term. Federal consolidation allows you to extend repayment up to 30 years by choosing from one of the federal repayment plans. You must select one during the application process. The shortest term length is 10 years under the standard repayment plan.
But you can opt for a repayment term as short as five years with refinancing. Typical loan repayment terms for refinance loans are five, seven, 10, 15, and 20 years, though some lenders allow you to choose any year term you want.
However, you probably shouldn’t be considering refinancing student loans if you can’t repay your loan in 10 years. The purpose of refinancing is to save you money. One way it does so is by getting you a lower interest rate. Taking more than 10 years to repay the loan extends the length of time you’re paying interest, meaning you could end up paying just as much or more on a longer loan with a lower interest rate than a shorter loan with a higher one.
In fact, one of the best ways to save money on your student loans is to pay them off as quickly as possible. Regardless of the interest rate, the longer you take to repay your loan, the more you repay in total.
For example, if you repay a $10,000 loan at a 5% interest rate over five years, you’ll pay $1,323 in interest. But if you take 10 years, it will cost you $2,728 in interest.
Refinancing can be an ideal way to help you pay off your student loans fast because it can reduce the overall cost of your loan, but only if you opt for a shorter repayment term.
If your student loan payments are too high on a standard 10-year repayment plan and you’re looking into refinancing because you need lower monthly payments, you’re better off sticking with federal loan consolidation, even if it means a higher interest rate.
That’s because your primary financial concern isn’t saving money. It’s making it from one paycheck to the next.
Federal consolidation preserves your access to federal repayment options like income-driven repayment, which allows you to make income-based repayments. Payments are fixed at a percentage (usually 10%) of your discretionary annual income, which is typically calculated as the difference between your adjusted gross income and 150% of the poverty level in your state for a family of your size.
It also ensures you qualify for federal student loan forgiveness programs, such as the Public Service Loan Forgiveness Program. When you consolidate your student loans, you can select an income-driven plan. After making 20 to 25 years of qualifying payments, depending on the plan, any remaining loan balance becomes eligible for forgiveness. With public-service forgiveness, the government can forgive your loan balance in as little as 10 years if you work full time in a public-service job.
3. Consider the Benefits of Refinancing
Once you’ve compared the most significant ways to save money with a refinance loan over a consolidation loan, look at any special discounts or perks offered by specific lenders you’re considering.
Most private lenders offer autopay discounts. But so do most federal loan servicers. The best refinance lenders go further and offer benefits the ED doesn’t. For example, Citizens Bank and Laurel Road offer additional rate-reduction discounts for opening linked checking or savings accounts.
Earnest allows you to customize your payments to fit your budget or payoff goals. You can choose biweekly or monthly payments, increase the size of your payments, make extra payments, or adjust payment dates at any time.
PenFed lets you and your spouse refinance your student loans into a single loan, which isn’t possible with a federal consolidation loan. Depending on your situation and whether you can get a lower interest rate than both your previous loans combined, that can be an effective way to tackle debt together.
SoFi offers free career coaching and financial planning to its borrowers. And Education Loan Finance, often known as ELFI, matches borrowers with a personal loan advisor, who they can call, text, or email with questions throughout the application process and the life of their loan.
CommonBond stands out to those with a passion for social causes. Its loans help fund the education of children in developing nations.
Additionally, some private lenders offer special perks for certain types of borrowers. For example, Splash Financial and Laurel Road offer medical residents the ability to make low, flat-rate $100-per-month loan payments during their residencies, which is potentially lower than what you’d pay in an IDR plan.
4. Consider the Benefits of Federal Loan Consolidation
While refinancing with a private lender can save you money and come with special perks, you also lose a lot when you refinance.
Private lenders rarely offer income-based repayment options, and none offer anything like the ED’s plans. Plus, even though you’re asked to choose a repayment plan during the application process, the ED allows you to change it at any time if your circumstances change. Private lenders don’t tend to be as flexible.
Moreover, the ED has generous deferment and forbearance terms. You can defer your loans indefinitely while you’re enrolled in school at least half time. And you can defer for economic hardship for three years. But if you’re unable to pay your loans for a longer period, enrolling in an income-based plan could qualify you for as low as a $0 payment, especially if you’re unemployed. And that $0 payment even counts toward your forgiveness clock.
You can also forbear loans for up to an additional three years, although you won’t make any progress toward forgiveness with that option.
But most private refinance lenders only offer a total deferment or forbearance period of 12 to 36 months. And 36 months is rare. If you’re considering refinancing your undergraduate student loans before grad school, private lenders are unlikely to give you enough time to finish before you have to start making payments on your refinance loan.
Plus, deferment and forbearance with private lenders tend to be aggregate, meaning if they give you 12 months of deferment or forbearance, using four months of deferment means you only have eight months left for either deferment or forbearance. So if you use all that up while you’re getting your graduate degree, you have no economic hardship deferment left if you have trouble finding a job.
But with the ED, no deferment you take impacts your forbearance or vice versa.
Finally, numerous borrower protections come with federal student loans. These protect you in cases in extenuating circumstances making repayment of the loan an undue burden. These include:
- Your school closed while you were enrolled
- Your school failed to refund the loan servicer after you dropped out
- Your school falsely certified your eligibility for a loan
- Your school misled you or engaged in other misconduct
- You become totally and permanently disabled
- You die
- You declare bankruptcy
Many private student loans don’t come with these kinds of protections, which means even if you become totally and permanently disabled and can’t work, you’re still responsible for repaying the loan. Likewise, many private loans aren’t dischargeable in death, which means they become a credit against your estate if you die.
Some private loans do offer at least a few borrower protections, though. So read your loan contract in its entirety before you sign.
Most student loan experts agree it’s generally not a good idea to refinance federal student loans because you lose access to all the federal repayment programs, generous deferment and forbearance terms, and borrower protections. Even if you think you won’t need them, no one can predict the future.
Plus, right now is a bad time to refinance federal student loans because the government has suspended payments and interest through Aug. 31, 2022, due to the ongoing COVID-19 pandemic.
If you refinance your loans now, you must start paying interest and making payments. However, if you have private student loans, there’s no harm in refinancing, especially if you can lock in a better rate than what’s on your current loans.
While the interest rate is the primary factor in saving money, it’s not the only thing that matters. When comparing private student loan offers, look for flexible repayment options, borrower protections, deferment and forbearance terms, and any special discounts and perks.