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How Does Refinancing Student Loans Work?

by Refi.me Staff on December 2 2020

Student loan refinancing involves paying off your current loans and taking a new one with different terms. The primary benefit of refinancing is the potential to pay a lower interest rate on the new loan. Despite the attraction of lower rates, this is not necessarily the best option for you. And even if it is, you will need to meet certain requirements in order to benefit from refinancing. Understanding how refinancing student loans works will help you make more informed decisions.

Eligibility Criteria for Refinancing

Most lenders will require you to meet these two criteria to get approved for refinancing:

  1. Good credit score
  2. Low debt-to-income ratio

Lenders will want to see proof of stable income with sufficient cash flow to support your new loan.

If you don’t meet the above two requirements, you may still be able to qualify for refinancing with a creditworthy cosigner. When you refinance with a cosigner, the cosigner acts as a guarantor for the loan. If you miss payments or default on the loan, the cosigner becomes responsible for making the payments. This reduces the risk to the lender, making it easier for you to get approved.

How Interest Rates are Calculated on Refinanced Loans

Lenders will offer you a personalized rate based on your financial circumstances. A high credit score and low debt-to-income ratio will get you the lowest possible rate.

When you inquire about refinancing loan rates, the lender will first do a soft pull on your credit history. If your credit score isn’t all that great, they may reject your approval right away. Or, they may approve your application, but will quote you a higher than average interest rate. If your credit score is good, you will get a lower rate of interest.

The lender will also want to know your debt-to-income ratio. This is your total monthly debt compared to your total monthly income. A high debt-to-income ratio means you are more likely to struggle with your loan payments. This makes you a high risk borrower. To protect their investment, the lender will charge you a higher interest rate. A low debt-to-income ratio is good and will get you a lower interest rate quote.

The first quote the lender calculates is only the estimated rate, not the final one. After you submit your completed loan application, the lender will do a hard credit check. This allows them to check your entire credit history. The lender will then quote a finalized rate based on their assessment of your creditworthiness. This finalized quote may be slightly different than the estimated quote.

Refinancing and Your Credit Score

Refinancing is a great way to build your credit score. The lower interest rates and altered monthly payments make it easier for you to manage your loan. Consistent timely loan payments are a key factor in building your credit score over time.

However, going about the refinancing process the wrong way could hurt your credit score. Every hard check on your credit will cause a small drop in your score. While one hard check won’t make much difference, multiple hard checks can damage your credit score considerably.

If you need to submit multiple loan applications, you must be careful about the loan application window. Ideally, you should submit multiple applications within a thirty-day window to protect your credit score.

Important Things to Know About Refinancing

The federal government does not offer student loan refinancing. Only private lenders do. When you refinance federal student loans, they get converted to private loans. This means you will lose all perks and protections associated with the original loan.

This is something you must think about carefully before you refinance federal student loans. More so at this time because of the concessions being offered by the federal government as part of relief efforts due to the coronavirus pandemic. Only refinance federal loans if you’re sure you don’t intend to pursue any protections associated with those loans.

When to Refinance Student Loans & When Not To

We said earlier that refinancing student loans may not be the best option for everybody. Under certain circumstances, you may be better off choosing another option. Here’s an overview of when you should consider refinancing and when you shouldn’t.

Refinancing is a good option if:

  • Your finances have improved and you qualify for interest rates that are lower than your current rates
  • The six month grace period on your federal student loans has elapsed
  • You have student loans with high variable rates
  • Prevailing market interest rates are low
  • You are not pursuing student loan forgiveness

Don’t wait for the perfect set of circumstances to get the lowest refinancing rates. It’s a smart idea to refinance your student loans as soon as you qualify for a better rate. Your savings will start from day one and will keep adding up over the life of the loan. Even a smallest drop in interest rate can add up to substantial savings. Moreover, you can refinance student loans multiple times. When your finances improve some more, apply for refinancing again for further savings.

Refinancing may not be the right option if you:

  • Have low-cost federal loans and see a potential drop in earnings
  • Are pursuing student loan forgiveness
  • Defaulted on student debt recently
  • Declared bankruptcy recently

Choosing the Best Refinancing Terms for You

When you refinance your student loans, you will be able to choose new terms on the new loan.

A longer repayment term will lower your monthly payments, but it will also increase the cost of your loan. Choose this option only if your budget is already stretched to the limit and you’re struggling to pay your debts every month.

A shorter repayment term will increase your monthly payments but you will save a lot on the accrued interest. This is a preferable option but only if you’re sure you can afford the higher monthly payments. Don’t be tempted to choose this option if you are already struggling with payments. Missing a payment can damage your credit score, which can have long term consequences. It’s not worth it.

We hoped you enjoyed this article! Remember, you can compare your personalized rates with our lending partners and potentially lower your monthly student loan payments and save money.

The Refi.me team is always here to help you