The Student Loan Conundrum: To Refinance or Not to Refinance

By Natalie Hayes Schmook, MBA, CFP, CVA

An interesting dilemma for younger ODS these days is whether to refinance their federal student loans into private loans. Payment deferrals on federal loans, which means that principal balances are not owed and the interest rate has been reduced to 0 percent, are set to expire on January 31, 2022. Typically these federal loans carry interest rates between 5 percent and 7 percent.

Contrast that with private student loans, where I’ve seen recent quotes below 3 percent to refinance. Historically speaking, that is an amazingly low long-term rate. But 0 percent and no payments? Even better.

So when is the right time to transition from a federal loan to a private loan? Unfortunately, it’s a bit of a gamble at this point, and there are two main forces and an uncertainty at play: interest rates, supply and demand, and opportunity cost.

Interest rates– Interest rates, largely set by the Federal Reserve, are extremely low right now in an attempt to stimulate the economy despite pandemic woes. On the other hand, inflation YTD is well over 5 percent, a normal parameter that would cause the Fed to raise rates, which would affect everything from car loans to mortgages to –you guessed it — student loans. It’s expected the Fed will begin raising rates next year, but that doesn’t mean other lenders won’t pre-emptively raise rates in expectation of a future increase, We have already seen this with mortgages.

Supply and demand– Even though interest rates are low, historically student loans aren’t the best credit risk, so seeing rates in line with high credit mortgage rates is a bit surprising. It’s possible that with 0 percent federal loan rates, private loan companies are artificially offering lower rates just to get loans coming in the door and as federal loan rates inch closer to expiring, private loan rates will start to decrease.

Opportunity cost– The real clincher in this dilemma of when to refinance is the possibility that the government extends 0 percent interest on federal loans beyond January 31, 2022, in which case you’d be paying more by refinancing now. It’s important to note there has been an overall slowing of government aid as we (hopefully) near the end of COVID-19.

So what should ODs do? Personally I’m not much of a gambler. I didn’t touch a single table at Vision Expo West—and I like to work with the information I do know.

SCENARIOS

Let’s assume you have $100,000 in student loans.

Refinance now into a 10-year loan at 3 percent, but then the federal loan deferral gets extended until November of 2022. Theoretically, you’ve paid $3,000 in extra interest you wouldn’t otherwise pay ($100,000 x 3% per year), less if you’re able to deduct the interest on your tax returns.

In the meantime, interest rates on private loans increase from 3 percent to 4 percent. Assuming you don’t make principal payments (which I highly recommend doctors do), you then refinance into a 10-year loan at 4 percent a year from now. Over 10 years, you’ll have paid $10,000 extra in interest ($100,000 x an extra 1% x 10 years) versus the extra $3,000 you paid in year 1.

At the end of the day, in my opinion, refinancing now in a worst-case scenario would mostly likely be a wash with waiting to see what happens in the future. Best case is that you get an amazing rate for the next 10 years.

Happy loan shopping!

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