Nearly 50 million Americans have student loan debt. Ask any one of them and they can tell you something far more enjoyable they’d rather do with that monthly payment. Dubbed a national crisis, student loan debt has created an opportunity for a new wave of social finance lenders to shine. Private lenders like SoFi, LendingClub, CommonBond, and Earnest are all over social media (and now TV) boasting five-figure savings and fairytale endings. Some states have even begun to offer student loan refinance programs, such as Minnesota’s SELF Refi Program. The several billions in refinanced dollars over only a few short years suggest that refinancing is something anyone with a student loan should at least consider.
Under the right circumstances, refinancing student loans can be a powerful way to lower interest rates and in turn change the trajectory of financial plan. How does it work? Is it for you? Let’s dive in.
Pay Down Debt or Invest?
Looking objectively at a financial plan that involves student loans often leads to one age old question: is it better to pay minimum balances and invest the difference, or to aggressively pay off loans before investing? The answer certainly depends on multiple variables including risk aversion, tolerance to hold debt, and Biblical convictions. A good financial planner should ask the right questions and help determine the best course of action individually and not as a rule. Regardless, it is hard to suggest focusing on anything other than paying down a loan if the interest is at 6-10% or more – especially given the volatile stock market we’ve seen lately. Refinancing to a lower rate, however, can change all that.
A Practical Example
Consider a married couple carrying a student loan balance of $33,000 at 6.8% with 7 years of payments remaining. If only the minimum payments of $495 are made each month then the total paid, with interest, will be $41,563. Now consider the couple refinances and qualifies for 3.99% fixed interest with a 5 year term and monthly payment of $608. By only making the new minimum monthly payments the total cost over the life of the loan is reduced to $36,441 -- a savings of over $5,000!
But let’s go one step further with this example. Let’s consider the same situation, only in this case the couple has $1,500/month of disposable income to put either towards student loans or to invest in a tax-advantaged IRA. For simplicity, the couple expects a return of 6.8% on any investments made.
Before refinancing, and at an initial interest rate of 6.8%, the couple elects to put all disposable income towards one large monthly loan payment. Expecting to pay back the loan after two years, the couple plans to then switch over and begin investing the $1,500 each month.
After refinancing, however, the couple qualifies for 3.99% fixed interest with a 5 year term. The couple now considers electing to pay only the monthly minimum of $608 per month and instead begins immediately investing the remaining $892 per month.
Here is how the two scenarios play out after 5 years:
In both scenarios the student loan gets paid off within 5 years, but the portfolio balance after the refinance was more than $3,500 higher. How does this happen when the total invested is less and the amount paid on the loan was more? The answer: compound interest. Although slightly less was actually invested after refinancing, it was invested earlier resulting in higher earnings over time. Of course, you could extrapolate this over a lifetime and the difference becomes astronomical.
Additionally, this does not factor in the student loan interest rate tax deduction currently set by the IRS at up to $2,500 annually. The couple actually gains even more of an advantage from the tax deduction because refinancing encouraged them to stretch out the loan in favor of investing. Depending on their tax bracket, this could result in an additional benefit of up to $400!
Refinancing to a private loan isn’t automatically the best option for every circumstance. Federal student loans come with unique benefits like deferment, forbearance due to financial hardship, and in some cases full or partial forgiveness. These benefits get surrendered when refinancing with a private lender. The value of these benefits varies based on circumstances. Additionally, not everyone who applies will qualify for a significantly lower rate. Therefore, the decision to refinance is largely a function of comparing the interest rate reduction to the likelihood of needing to exercise any of the benefits that come with a federal loan.
Take the Next Step
Wacek Financial Planning can help make sense of student loans. We help individuals and families step back from stress of that monthly loan payment, see the big picture, and have a plan in which they can feel confident. Reach out today and let’s have a conversation about getting ahead of student loans.
Wacek Financial Planning is not paid or endorsed by any of the social finance lenders mentioned in this article.
About Wacek Financial Planning
Founder, Ben Wacek, is a fee-only, Certified Financial PlannerTM who has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective, using Biblical principles. If you’d like to learn more about Wacek Financial Planning, please visit www.wacekfp.com.
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