Refinancing and Consolidation: Which is Right for Me?

How do mistakes happen?

When people get confused. This is especially true when it comes to dealing with student loans. Not only do you have to learn a new language specific to student loans, but you also have a new repayment plan/option that seems to materialize once every few years, complete with confusing acronyms. There can be a breakdown in communication when two people are having a conversation and they aren’t even using the correct terminology.

Consolidation and refinancing are two terms that are often confused with one another, sometimes used interchangeably. Before diving deeper into student loans, I wouldn’t have known the difference between the two.

If you’re paying off your loans (or will be in the future), it’s important to know that they are NOT the same thing. Read on to see why it’s so important to know the difference, and who would benefit the most from consolidation or refinancing.

CONSOLIDATION

A Direct Consolidation Loan is a federal loan. The purpose of this loan is to bundle eligible federal loans into one loan.

MULTIPLE ELIGIBLE FEDERAL LOANS –> 1  FEDERAL DIRECT CONSOLIDATION LOAN

Here is a PSA: Apparently, there are some private companies that are charging a fee to apply for a Direct Consolidation Loan. Here is a direct quote from the US Department of Education Federal Student Aid website:

“There is no application fee to consolidate your federal education loans into a Direct Consolidation Loan. You may be contacted by private companies that offer to help you apply for a Direct Consolidation Loan, for a fee. These companies have no affiliation with the U.S. Department of Education (ED) or ED’s consolidation loan servicers. There’s no need to pay anyone for assistance in getting a Direct Consolidation Loan. The application process is easy and free.

https://studentaid.ed.gov/sa/repay-loans/consolidation

WHAT ARE THE BENEFITS OF CONSOLIDATION?

If you have multiple loans +/- multiple loan servicers, converting them into a Direct Consolidation Loan simplifies your loan situation so that you only have to manage one loan with one loan servicer. 

Another important benefit is that consolidation will allow you to choose an income-driven repayment plan (such as IBR, PAYE, and REPAYE), which in turn offers you the chance for student loan forgiveness.  If you currently have federal loans that are not on track to be forgiven, then rolling them into a Direct Consolidation Loan will give you this opportunity.

WHAT ARE THE DRAWBACKS TO CONSOLIDATION?

If you are already making qualified payments towards forgiveness, then consolidation restarts your clock. If forgiveness is your ultimate goal, it’s best to consolidate as early as possible so that every payment counts towards forgiveness. 

Also, your interest capitalizes once you consolidate your loans, meaning that any accrued interest is now added to your principal. This increases your repayment balance. 

Please refer to these following links for further information about consolidation:

Federal Student Aid: Loan Consolidation (from the US Department of Education)

VIN Foundation New Grad Student Loan Questions and Answers: Consolidation

REFINANCING

The reason that refinancing is often confused with consolidation is that they BOTH combine multiple loans into one loan.

However, the difference is that refinancing is the process of turning multiple loans, whether they be federal or private, into a private loan. 

MULTIPLE LOANS (FEDERAL AND/OR PRIVATE) –> 1 PRIVATE LOAN

WHAT ARE THE BENEFITS OF REFINANCING?

It all comes down to interest rates. With a Direct Consolidation Loan, your interest rate is fixed, and it is calculated by using a weighted average of the loans that were consolidated, rounded up to the nearest 1/8th percent (that last 1/8th percent seems so random, doesn’t it?). 

However, when you refinance with a private lender, you have the potential to significantly lower your interest rate. When you’re talking about a loan balance of 5 to 6 figures, this results in massive amounts of savings in interest alone.

Starting Balance	$100,000	$100,000
Loan Term	10 Years	10 Years
Interest Rate	7%	4%
Total Interest Paid	$39,330.18	$21,494.17

In this example, a 3% different in interest rates results in lowering your monthly payment by $148.63 and saving $17,836.01 in total interest payments. Not too shabby!

Those who are looking to accelerate their debt payoff often turn to refinancing in order to speed up the process. 

 WHAT ARE THE DRAWBACKS TO REFINANCING?

However, as with anything, there are drawbacks. 

Federal loans have the advantage of offering income-driven repayment plans. These plans base your payments on your income, NOT your loan amount. Regardless of whether you owe $100,000 or $500,000, you will have the same monthly payment on a $70,000 income. At the end of your loan term, you will have your loans forgiven. The forgiven amount is considered taxable income, so you will be expected to pay your “tax bomb” at the end of the repayment period.

If you’re eligible for the PSLF program, which you can read more about here, then you will owe no taxes on the forgiven amount after 120 qualifying payments (minimum 10 years).

The introduction of income-driven repayment plans with forgiveness has dramatically changed the strategy of paying back your student loans. The higher your debt to income ratio, the less likely it makes mathematical sense to pay your loans off completely.

You can run some calculations by using the VIN Foundation Student Loan Repayment Simulator.

However, remember that this is not an easy calculation due to a variety of factors and assumptions that you will need to make when running your numbers. This is why it is so important to take into account your whole financial picture before making the decision to stay on an income-driven repayment plan or opt out by refinancing.

There are also other perks offered by having a federal loan:

1.Deferment/Forbearance: If you’re in a situation where you need to temporarily stop making payments on your federal loans, or you need your payment amounts temporarily reduced, you can enter a deferment or forbearance period. 

Interest will continue to accrue during the deferment/forbearance period. However, with deferment, there are certain loans where you will still be responsible for paying interest accrued during the deferment period. If you are in forbearance, you will be responsible for the interest that accrues on all types of federal loans. 

You can read more about deferment and forbearance here. 

2. Discharge upon death or total and permanent disability: This is a feature that gives people some peace of mind. You can read more about discharge upon death/TPD here. 

SO SHOULD I REFINANCE?

This is a question that will require you to carefully weigh the pros and cons of this decision. Once you refinance your federal loans, you will lose the benefits that come with federal loans. 

Here are some questions you should ask yourself as you’re making this decision:

1. Do I have private loans? Since these loans aren’t eligible for the federal income-driven repayment plans and forgiveness options, anyone with a private loan should almost always be on the lookout for refinancing and getting a better interest rate on their current private loan(s).
2. Am I okay with forgoing forgiveness options? You need to answer with a firm yes if you are planning on refinancing your loans.
3. What’s my credit score? As with borrowing any money, the higher your credit score, the better your chances at qualifying for lower interest rates. Submitting a full application for refinancing can lower your credit score, but this should be a small, temporary dip. You can read more about credit scores and credit reports here.
4. What is my debt to income ratio? Lenders are more likely to offer you a refinancing deal if you have a debt to income ratio of 50% or less. Included in this calculation are the following: mortgage/rent, car loan/lease, student loans, minimum credit card payment, and child support. If half of your income is going towards debt repayment, then you will be less likely to qualify for refinancing since paying off debt is taking up so much of your monthly income. 
5. Can I stick with the projected monthly payments? It’s important that you carefully evaluate your projected monthly payments. Being on an income-driven repayment plan means that if your income drops or you lose your job, your monthly payment will be adjusted accordingly, potentially down to zero. You lose this protection when you refinance your loans. You MUST be confident that you can cover your monthly payments, regardless of how your income may change over time.
6. Will I need a co-signor? Sometimes a borrower needs to bring in a co-signor in order to qualify for refinancing. You and the co-signor need to be very comfortable with this arrangement.
7. Do I qualify for PSLF? This forgiveness program is quite valuable, and if you’re eligible, it’s worth looking into whether it would make more sense to forgo refinancing so that you can take advantage of this program.
8. Is there a prepayment penalty? You want to make sure there is no penalty for your exuberance to pay off your loans early!
9. Are there any fees, such as an origination fee or application fee? Fees can add up, so make sure you’re very clear on what they are and are not charging you.
10. Have I shopped around? The refinancing world is very competitive. The focus tends to be on the interest rates, but as you can see, there are many other factors that play a role in your final decision. Don’t focus solely on the interest rate. Pay attention to whether the interest rate is fixed or variable. Pay attention to the loan repayment term. Do they offer any deferment or forbearance? See if that lender is offering other perks that other lenders don’t.

When you refinance, remember that you can refinance as often as you want. Until your loans are paid off, it’s a good idea to shop around on a regular basis so that you’re getting the best deal possible.

CONCLUSION

As you can see, there are major differences between consolidation and refinancing. Understanding the correct terminology is the first step to making the best long term student loan payback strategy. 

If you are going for forgiveness and need to stay on an income-driven repayment plan, then it makes sense to consolidate all eligible loans as early as possible. 

If you have private loans, and/or you are wanting to pay your loans off quickly with no plans for forgiveness, then go for refinancing. 

Here is a free online calculator you can use to run some numbers that compare consolidation and refinancing. 

If you’re ready to refinance, please check out my Refinancing Student Loans page for current offers and cashback bonuses!

If you need some more information regarding student loan advice, make sure to check out my Student Loan Advice page for more information and resources. You’ve got this!

Have you consolidated or refinanced your loans? How was the experience? Comment below!