By Steve Nicastro, NerdWallet
Refinancing student loans may reduce the monthly payment, but taking that step can be a poor financial move if the bulk of the interest due has already been paid.
Often, borrowers refinance to consolidate their loans and simplify payments while cutting the interest rate on the remaining balance. However, any savings that may be achieved – or extra costs incurred – depends on the timing. Taken too late in the life of the original debt, these steps can raise the final interest expense, while acting early can produce significant savings.
“Earlier principal payments will shorten the length of the loan more dramatically than extra payments made in future years – which means that it does benefit you to make extra payments or refinance early to reduce your total interest payments over the life of the loan,” says Scott Stratton, a certified financial planner and chartered financial analyst with Good Life Wealth Management in Dallas.
Debt tied to getting through college has become a crushing burden for many young Americans. The average 2014 graduate walked away with $33,000 in loans along with a diploma, according to the Wall Street Journal. They joined the estimated 37 million others carrying a financial legacy from getting that sheepskin, with about $1.1 trillion in principal outstanding, according to the Federal Reserve Bank of New York. A lot of those borrowers are understandably pondering ways to deal more effectively with these obligations.
One issue that comes into play is that student loans amortize, just like home mortgages. As a result, for those who have been paying off loans for some time, refinancing may not make sense. Much of the interest on the original debt may already have been paid, and taking on new loans can increase that cost. Nerdwallet’s student loan repayment calculator shows much a student loan will cost in interest.
Amortization is the elimination of debt over time with fixed regular payments. Like mortgage notes, the amortization schedule for most student loans requires the borrower to pay off the bulk of the interest that will be due over the note’s full term early in the repayment period. On a 10-year student loan, the standard term for a federally backed education note, that structure means the borrower will typically have paid about half the total interest due by the end of the third year of repayment.
Take a $300,000, 30-year fixed mortgage as an example. In the chart below, the blue line represents the portion of each monthly payment that covers interest, while the green line is for principal. About half the interest owed will have been paid by the middle of the 11th year, while the principal will reach that point a decade later.
Sensible student loan refinancing
So refinancing a student loan may not save anything, and could increase total interest costs, if the move is made too late in the original loan’s repayment schedule, since taking on a new debt re-sets the amortization schedule. However, taking that step within the first few years of repayment can cut those costs. Amortization calculators available online can help determine when that point arrives with any debt.
If the timing isn’t right, it may be a better idea to pay off higher-interest obligations like credit card balances or an auto loan instead. Investing may be a more productive way to use any extra money available, says Bennie D. Waller, who teaches finance and real estate at Virginia’s Longwood University in Farmville.
“For younger people that can afford to take some volatility risk, investing in the stock market based on historical returns would offer a superior return to paying off loans,” Waller said. “Keep in mind that some borrowers may also enjoy tax benefits from student loans in that interest may be tax deductible.”
Many people refinance loans to lower the monthly payment amount to a more affordable level, despite the increase in interest costs that may result. This would be a good move, especially for those at risk of defaulting, or failing to make required payments, which puts a black mark on the debtor’s credit history. Some borrowers may be willing to pay more in interest in exchange for simplifying their finances, for example, by reducing seven or eight separate payments to a more manageable one each month.
While figuring out what steps make sense depends on individual circumstances, understanding how student loans work can help clarify the best course of action.
Steve Nicastro is a staff writer at NerdWallet, a website devoted to helping consumers make smart financial decisions. The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.