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Student loan refinancing is a great idea — except when it's not

When Christina Wallace, 31, took out loans to cover her tuition for Harvard Business School in 2008, she was stuck with nearly $100,000 in federal student loans at a fixed rate of 8%. By the time her loans came due in 2010, interest rates had plummeted, but she wasn’t able to take advantage of them and refinance.

As it stands, federal student loan borrowers can consolidate their loans but can’t refinance to lower interest rates available today as one would with a mortgage. A consolidation only averages the rates of your current loans to come up with your new rate.

Government officials are debating whether to allow students to refinance federal student debt. Meanwhile, online start-ups-turned-refinancing-juggernauts SoFi and CommonBond have stepped in to fill that void. And some traditional credit unions and banks, including Darien Rowayton Bank, Alliant Credit Union and Wells Fargo, have followed suit. 

Wallace decided to refinance her graduate school debt through CommonBond in 2013. She was able to lower her interest rate to 5.9% from 7.8%, saving her a few hundred dollars a month in interest payments.

“It all seemed too good to be true initially,” says Wallace, who works at the American Museum of Natural History in New York. “But I liked the idea of supporting a New York start-up, and when I ran my calculation on their site, I saw that I could save a lot by refinancing.”

This is all great, but (and this is a big “but”) student loan refinancing is not the panacea for our national student debt problem. Refinancing only works for borrowers in a very specific set of circumstances.

Here are some important factors to consider before you consider student loan refinancing:

1. Broke art majors need not apply.  

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We all know that newly minted college graduates aren’t exactly in the greatest financial shape, but if you’ve missed one student loan payment in the past, you could be out of luck if you want to refinance. 

“Our program is really not for people who don’t expect to [make payments on time],” says Aryea Aranoff, director of education finance strategy at Connecticut-based Darien Rowayton Bank.

DRB’s refinancing requirements are pretty stiff: They want candidates who have FICO scores of at least 680 and a debt-to-income (DTI) ratio lower than 40%, which means your total debts shouldn’t be more than 40% of your income.

Nontraditional lenders like CommonBond and SoFi don’t necessarily focus exclusively on DTI and credit scores, but they have equally high standards. SoFI requires borrowers to have credit score of at least 700, according to a report by credit ratings industry analyst DRBS, although the company will consider lenders with lower scores if they can prove sufficient cashflow ($2,000+ per month). The average SoFi borrower earns $142,414 per year — three times the avearge 2014 college graduate — and has a credit score of 776*.

CommonBond specifically targets high-earning graduate-degree-holders like Wallace (e.g.: the kind of folks who will likely be able to make payments on time). To be eligible, borrowers must have earned a graduate level degree or higher in a specific field of study like medicine, accounting, law, engineering, or finance, among others. And that degree must have been earned from a list of schools CommonBond has preselected, which varies by industry. For example, they prefer that a borrower who has a Master’s in Finance also hails from one of 13 schools, including Johns Hopkins University or Princeton.

SoFi won’t deny fine arts majors based on their degree alone, says co-founder Dan Macklin. Although educational history is the chief factor they consider before approving a loan applicant, they also judge based on employment history, income, and credit history.  

“Our underwriting approach is nontraditional,” Macklin says. “If somebody hasn’t been paying their bills in the past then it counts against them, but it’s not the sole [criterion] we’re looking at.”

2. Lower rates aren’t all they’re cracked up to be.

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Refinancing offers can be a pretty sweet deal, especially if you’re like Wallace and got stuck with high pre-recession fixed-interest rate loans. But not all refinanced loans are the same, and it’s important to pay attention to the terms of your specific loan.

Most lenders that offer student loan refinancing give borrowers the option to take out loans in 5-, 10-, 15-, and 20-year terms. Rates typically start around 3.5% for fixed loans and 2% for variable loans.

A longer term loan will give you more time to pay and lower monthly payments, but that extra time will cost you in the form of higher interest rates. For example, DRB charges 3.5%-4.75% on 5-year fixed-rate loans and 6% on 20-year fixed-rate loans. A 20-year variable rate loan at DRB starts at 3.98% but can go as high as 9%, much higher than rates on federal student loans today.

“Be careful, especially with variable-rate loans,” says Nick Clements, CEO of Magnify Money, a consumer finance education website. “We may be at all-time low interest rates but what we know for sure is that over the next 30 years they will go up at some point.”

There are other ways to get lower monthly payments besides refinancing. Ask your lenders if they offer a loan modification program like Pay as You Earn offered to federal student loan borrowers, which allows you to lower your payments based on your current income.

Shop around, too. It won’t hurt your credit. FICO, the company that provides the credit scores most lenders use, has promised to count any student loan refinancing applications filled out during a 30-day period as only one hard credit inquiry on your credit report, which would mean only a small dent in your credit score, Clements says.

3. You are giving up your federal loan safety net.

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Federal student loans are by far the superior loan option for one simple reason: they have way better repayment options than private lenders. You can put your loans into forbearance, defer them, apply for income-based repayment to reduce your payments or apply for loan consolidation. Once you refinance that debt into a private loan, you no longer get those options.

“You’re giving up future flexibility for something that may be cheaper now. You never know what could happen,” says Persis Yu, an attorney with the National Consumer Law Center.

Most private lenders that offer refinancing aren’t as forgiving to borrowers who fall on hard times as the government is. DRB says it offers no safety net for borrowers who miss payments. Once your bill is 15 days late, they either charge the lesser of 5% of the amount due or $28.  

“What we’re saying is that if you’re staying with the federal loan program, you are paying [higher interest rates] to get access to those [repayment] programs,” says Aranoff. “We are willing to give a lower rate to people who don’t want to buy that access.”

SoFi and CommonBond are a bit kinder. Each offers some form of unemployment protection that lets you defer loans if you find yourself out of a job (in three-month increments for up to 12 months). They also have teams on hand to help you find jobs in your field. When Wallace was out of work last summer, CommonBond actually gave her a three-week consulting gig at its Brooklyn, N.Y., office. Luckily, she found full-time work right before her deferment period ended. A company spokesperson says they haven’t experienced a default or an industry-standard delinquency since they launched in 2012.

Just make sure you read the loan’s terms carefully so you know what you’re in for.

Student loan refinancing is relatively new, so there isn’t one comprehensive tool that lets you compare rates, like you can easily find for things like credit cards. We recommend starting with this list of refinancing options from Magnify Money.

*In light of new information we received on the finances of SoFi borrowers, we updated this section to reflect their borrowing standards.

We are taking your questions 24/7 at Ask Yahoo Finance. Have a question? E-mail us at yfmoneymailbag@yahoo.com.

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