When should you refinance your student loan?

If you've recently graduated from college, or are preparing to, there could be options for refinancing your student loans that may make paying them easier. 

Pablo Martinez Monsivais/AP/File
The pen that President Barack Obama used to sign a Presidential Memorandum on reducing the burden of student loan debt, Monday, June 9, 2014, in the East Room of the White House in Washington. Student loans have reached all-time highs since.

It’s a lot more fun to celebrate college graduation than it is to develop a student loan repayment strategy. So if you’re a new grad with federal loans, you’ll likely end up on the default standard repayment plan, which requires you to pay a fixed amount every month for 10 years until your loans are paid off.

For some people, keeping up with payments under the standard plan can be a struggle. But if you’re earning a steady income and can afford your payments, then you can probably explore alternative repayment methods, such as refinancing your loans. Refinancing could save you money in interest and simplify your payments. It also means giving up protections that federal loans offer.

Here’s what you need to know to decide between refinancing and sticking with the standard plan.

The basics: Standard repayment plan

Around the time you graduate, you’ll complete an exit counseling session on the Federal Student Aid website. That’s when you’ll sign up for a federal student loan repayment plan.

Your student loan servicer will place you on the standard plan unless you choose a different one. Your monthly payment will be higher with the default option than it would be with some others, including income-based repayment, which caps your monthly loan bill at 10% or 15% of your income. You can also choose a graduated plan, in which you have a lower payment that increases every two years. But you’ll pay off your loans faster and owe less interest over time on the standard, 10-year schedule.

Remaining on a federal repayment plan has several benefits. You can apply to temporarily postpone or reduce your payments, and the government will even pay the interest on your subsidized loans during periods of deferment. If you work full-time in public service, the remaining balance of your loans could be forgiven after 120 qualifying payments through the Public Service Loan Forgiveness program.

The basics: Refinancing

When you refinance, a private lender pays off your existing loans and gives you one new loan that incorporates your remaining balances. The lender calculates your new interest rate and monthly payment based on your credit history and other financial factors. Most lenders let you choose between a fixed interest rate, which won’t change, and a variable interest rate, which increases or decreases according to market conditions.

If you’ve built strong credit and a solid employment history in the years since you graduated, you might receive a lower interest rate on your refinanced student loan than you received on your original loan.

However, your refinanced loan will be managed by a bank, not the federal government. That means you’ll give up the protections specific to federal loans. If you may want to take advantage of interest-free deferment on subsidized loans, loan forgiveness programs or income-driven repayment options, consider refinancing only your private loans and sticking with the standard, 10-year plan.

Which is best for you?

Consider continuing to repay your federal loans on the standard plan if you’ll take advantage of Public Service Loan Forgiveness or other benefits specific to federal loans. But if you work in the private sector, have a high level of job security and don’t plan to use federal student loan protections, you could save thousands of dollars by refinancing.

Here’s how it works: Say you took out a $10,000 Direct Unsubsidized Loan in 2011, during your junior year of college, at a 6.8% interest rate. You’ll pay $3,810 total in interest throughout a 10-year standard repayment term.

After making two years’ worth of payments on the loan, you’d still owe $8,503 on the principal and $2,545 in interest. But if you refinance the remaining $8,503 loan balance and receive a 5% interest rate on a five-year loan term, you’ll pay only $1,125 in interest. In the end, you’d save $1,420 in interest by refinancing.

Nerd note: Many lenders offer five-, 10-, 15- and 20-year loan terms. You’ll maximize your interest savings if you choose as short a repayment term as you can manage when you refinance. This will increase your monthly payment, but not always by much. In the example above, you’ll pay $167 per month for five years on your new refinanced loan, compared with $140 per month for eight years on the remainder of your original loan. That extra $27 a month might be worth it when you consider the $3,440 you’ll save overall.

What’s next?

If you decide to refinance, NerdWallet’s trusted partner Credible can help you find the best deal. Credible is a marketplace that lets you compare refinancing offers from as many as nine lenders at once. Successful Credible borrowers have credit scores of at least 680, unless they use a co-signer; annual incomes of at least $24,000 per year; and student loan balances that total $45,000 to $75,000. Each lender has its own requirements for the amount you can refinance, often based on your course of study.

This article first appeared at NerdWallet.

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