By Michael Kitces
Refinancing debt to consolidate multiple loans into a single one is a standard of debt management. There are many possible reasons to take such a step, including to get access to a more favorable interest rate, to reduce the monthly payments by stretching them out over a longer repayment period or to be able to make all the payments to one loan servicer.
When it comes to college loans, however, the refinancing picture is especially complex because today’s student loans are actually a combination of federal and private loan programs. To help alleviate explosive levels of college debt, federal student loans are getting access to multiple forms of flexible repayment plans. Some of these even include terms that allow unrepaid student loans to be forgiven after 25, 20 or even 10 years in some circumstances.
But flexible loan repayment programs are available only for federal student loans. In fact, old federal student loans under the prior Federal Family Education program can be consolidated into new federal loans eligible for flexible repayment and potential forgiveness under the Federal Direct Consolidation Loan program.
Unfortunately, though, students who refinance federal student loans into a private loan lose access to the flexible repayment and potential forgiveness programs. This means that, when it comes to student loans, refinancing — even if it’s for a lower interest rate or a smaller monthly payment — can actually be far more damaging in the long run than keeping the original federal loans, or simply consolidating into the latest federal programs.
BENEFITS OF DEBT CONSOLIDATION
For those who need to borrow money, debts can accrue from many sources. And ultimately, a large number of loans are at best unwieldy to oversee and manage — with a variety of loan servicers to pay, with varying interest rates and loan terms — and at worst can compound too rapidly and spiral out of control, leading to default and bankruptcy.
In this context, debt consolidation strategies have become increasingly popular in recent years as a means to manage multiple debts. Consolidating multiple loans into one can simplify the number of payments to make and manage, and may even save money in the long run by obtaining a lower overall interest rate.
Refinancing multiple loans into a single consolidated one can also be appealing if the new loan has a longer repayment period, which may significantly cut minimum debt payment obligations and make it easier to avoid default.
STUDENT LOAN DEBT EXPLOSION
Historically, the focus on debt consolidation has been around consumer debt, but there has been an explosion of student loan debt over the past decade.
With total student loans now exceeding all credit card debt in the U.S., there has been massive growth in refinancing and consolidation programs specifically for student loans, including traditional lenders like Citizens Bank, alternative lenders like Earnest and new nonbank marketplace lending alternatives like CommonBond and SoFi.
In general, when discussing consumer debt management, terms like consolidation and refinancing are often used interchangeably, as the act of consolidating multiple loans into one typically involves the action of refinancing them.
When it comes to student loans, there’s a difference between refinancing and just consolidating multiple loans into one, thanks to the Federal Direct Consolidation Loan program. This program combines multiple federal student loans into a single loan. This consolidation process doesn’t change the interest rate being charged, but it can stretch out payments over a longer period in some cases.
FAVORABLE FEDERAL PROGRAMS
More important, though, a Federal Direct Consolidation Loan can render the student loan borrower eligible for several flexible repayment programs only available for certain federal student loans, such as:
Income-Based Repayment. With IBR, payments are capped at 15% of the borrower’s discretionary income and can be as low as zero for those below 150% of the federal poverty level. Any excess interest is capitalized, with no maximum limit on negative amortization, but any remaining balance is forgiven after 25 years. This was cut to 20 years and a 10%-of-income cap for new borrowers since July 1, 2014. In order to qualify for IBR, the borrower must have a “partial financial hardship.”
Pay As Your Earn. Under PAYE, a student loan borrower’s monthly payments are capped at 10% of discretionary income. Again, excess interest may be capitalized in some circumstances (but is capped at up to 10% above the original principal amount). Also similar to IBR, if the borrower still has a balance after 20 years of payments, the balance is forgiven. PAYE is a more recent program, and older student loans may not be eligible.
Revised Pay As You Earn. REPAYE has terms similar to PAYE, where monthly payments are again capped at 10% of income, and it again allows forgiveness after 20 years (or 25 years for graduate school loans). However, negatively amortizing interest charges with REPAYE accrue at only 50% of the unpaid interest, and capitalize only if you leave the REPAYE program.
Public Student Loan Forgiveness. One challenge to IBR, PAYE and REPAYE is that any loan balances that are forgiven are taxable income to the borrower at that time. However, the PSLF program, which can apply on top of any of these programs, turns the forgiven loan from being taxable to non-taxable, and loan forgiveness periods can be as short as 10 years. However, PSLF is available only to those who work full-time in the public sector, which generally means working for the government, a 501(c)(3) charity or certain other qualifying nonprofit organizations.
Before 2010, federal student loans were administered by a combination of the federal government itself and the Federal Family Education Loan program, which facilitated federal loans through private company lenders. The caveat, however, was that only direct federal loans were eligible for the most generous payment and forgiveness programs, like PAYE and PSLF.
A FEDERAL TAKEOVER
In 2010, the Treasury took over the entire federal student loan program, and FFEL was phased out for new loans beginning after July 1, 2010. This means that all federal student loan programs since mid-2010 have been potentially eligible for at least some federal flexible payment programs. However, many former students still hold FFEL loans that were taken out before 2010, which were not eligible for certain payment programs. Fortunately, though, these loans can become eligible, if consolidated through the FFEL.
The significance of these rules is that not only can older student loans under FFEL potentially become eligible for more favorable loan terms by consolidating, but private loans are not eligible, and going through the process of refinancing a federal loan into a private loan will irrevocably lose access to these programs.
Many students may not even be aware of whether loans are actually federal loans or private loans. To make such a determination, students can request their federal loan information through the National Student Loan Data System, which will show any student loans that are actually part of federal programs and the relevant loan details.
CREDIT REPORT CHECKUP
To identify all other loans, students should get a copy of their credit report to identify all loans outstanding. Any loans that are shown on the credit report, and not listed in NSLDS, will be private loans.
Also, students should obtain a new copy of the actual promissory note for each private loan in order to really understand the loan terms and details.
Once this information has been gathered, it’s possible to organize all the details of the student loans, private and federal, FFEL or Direct, and the terms, to identify whether it makes sense to consolidate federal loans or refinance private loans.
Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. He’s also publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.
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