If your student loans are at high interest rates, refinancing may be a smart money idea. Consolidations, by contrast, offer no financial advantage. The difference is that refinancing pays off all of your old student loans (that are likely at several different interest rates) and the lender creates one larger loan at a (hopefully) more competitive rate. Consolidation, in contrast, pays off all of your old loans, but uses a weighted average of your interest rates as the rate for your new larger loan. This means the overall interest will be much the same.
Refinancing is the only way to get a more competitive rate than you currently have, but if you have several loans at different interest rates, as most people do, you’ll have to consider whether refinancing is advantageous. To test this out, let’s do the math on some different refinancing alternative for various student debt scenarios.
For each of the three scenarios, we’ll start from this baseline:
Loan balance $35,000
Loan #1 $5,000 at 7.8%
Loan #2 $6,000 at 7.3%
Loan #3 $10,000 at 6.86%
Loan #4 $10,000 at 3.86%
Loan #5 $4,000 at 6.5%
Total of monthly payments = $395
Total interest paid = $11,860
Total of all payments = $46,860
Average effective interest rate = 6.25%
Scenario #1: Refinancing at 5.8% on a fixed rate loan
With a starting balance of $35,000, the monthly payments on this refinance loan will be $385 (a modest saving). The overall interest paid drops a little as well to $11,207. The total paid on this loan will be $46,207. Monthly payments are 3% less, interest is 5.5% less and total overall savings are 1.4% less than the original loan. This would be a modestly advantageous refinance.
Scenario #2: Refinancing at 4.5% on a fixed rate loan
With the same starting balance, the lower interest rate would generate monthly payment amounts of $362 and an overall interest charge of $8,528. Total paid in would be $43,528. This is a significant savings. Monthly payments are 6% less, but the interest drops by a whopping 24% and the total paid by an impressive 6%. This re-fi interest rate is 1.75% less than the effective rate of the original loan – you can easily see what a big difference a sizable interest rate drop can make.
Scenario #3 Refinancing on a variable rate loan
Fixed rate loans are typical and are what you see in the original loan and the two scenarios above. The interest rate remains unchanged throughout the life of your loan. With a variable rate loan, it will fluctuate based on a flat rate plus a key index rate (usually LIBOR). You can usually get a lower starting rate on a variable rate loan, but the fluctuation can play havoc if it begins to rocket. Below is what happens with a loan that fluctuates:
Starting balance $35,000
Initial interest rate 2.91% that lasts for 2 years – monthly payment $336
Interest rate change to 4.75% that lasts for 3 years – monthly payment $361
Interest rate change to 5.82% that lasts for 4 years – monthly payment $370
Interest rate change to 7.63% that lasts for 1 year – monthly payment $374
The total interest paid out on this loan would be $8,351 and the total of all payments would be $43,360. Even with the interest rate spikes in the later periods, this loan is still the most advantageous, but it easily could have been worse for the borrower if the rate increased significantly earlier on in the loan. The monthly payment is preferable to the initial loan and the first scenario for all periods and better than the second scenario for half of the loan. The ultimate savings are 30% on interest and 7.4% on the total cost of the loan.
Caveats and final thoughts
With any refinance, there are some considerations. If you are refinancing only private loans, going for a lower rate loan is a no-brainer. If you have some federal loans in the mix though, you need to consider whether you might need flexible income sensitive repayments or if you are working in public service, refinancing could invalidate your forgiveness options.
If you are considering a refinance, there are a number of lenders that will work with you depending on your credit rating, income and other factors. A few that we like are SoFi, where you can get refinanced with fixed rates starting at 4.99% with Autopay and CommonBond, where rates start at 5.99%.
To keep track of your original loans or your refinanced loans, sign up for Tuition.io’s free student loan tool to monitor your balance, get reminders and countdown to your loan payoff date. And be sure to read our blog for tons of student loan tips and info.