When you take out a loan, you make an agreement: the lender gives you the money you need and you can pay it back over the next few years, plus interest. But that doesn’t have to be the end of it. You can take out a new loan, one with a smaller interest rate or better terms, and use it to pay off your existing loan. This includes student loans. However, there are a few things you should understand before you decide to refinance.
Consolidation Versus Refinancing
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In financing circles, “consolidation” means taking out one loan to pay off several more, like getting a bank loan to pay off the debt on three credit cards. But when it comes to student loans, “consolidation” is very specific. It means the federal government will consolidate all your federal student loans into a single loan. They only do this for federal loans, so if you also have a few private loans you have to either pay them separately or refinance with a private lender. However, private lenders will often refinance federal loans depending on which one you look at.
When you consolidate your student loans, it’s important to think about debt forgiveness programs. Since the federal government offers student loans for the public good and not for profit, the government is willing to forgive debts under certain conditions. Debt forgiveness means the government will reduce your debt by a big percentage but only if you meet the right conditions. That usually means you have to prove you can’t reasonably pay back the loan. So check whether your existing loans have the forgiveness feature and use it if you can before you consolidate.
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When you’re refinancing or consolidating student debt, you need to look at more than just the size of your monthly payment. You should also look at how flexible they are and what could make them change. For example, a refinanced private loan could let you suspend payments while you’re unemployed, and a consolidated federal loan could tie the payment size to your monthly income so the number is always reasonable. And if you already have benefits like these, it might not be worth refinancing to get what looks like a lower monthly payment.
Maybe you got a loan with a flexible interest rate but the market interest rate has gone up with no sign of shrinking. Maybe you have a fixed-rate loan and it’s much higher than the current flexible rate. Either way, refinancing lets you switch between the two loan types. It can also give you a better rate in general if your credit score has gone up since you first took out your loan. This feature doesn’t apply to most federal loans, but it can be an important way to reduce payments on private loans.
One last thing to remember is the early payment penalty that many private loans have. It usually isn’t much compared to the savings you could get from a big refinancing, but the number still adds to the cost of a new loan.