5 Reasons Why You Might Not Want to Refinance Your Federal Student Loans

Many private student lenders are making a big push for a piece of the student loan refinancing pie.

Banks and venture capital-backed nonbank financial services companies are hard at work slicing and dicing that trillion-dollar market into bite-size, demographically based refinancing opportunities. Their primary targets? Borrowers who have the best longer-term earnings potential because of the schools they attend, their areas of study or for other reasons.

The lure is in the form of seemingly lower rates and streamlined documentation processes, which, on the surface, presents a good deal of appeal. That is, for borrowers with higher-priced private student loans and perhaps state-sponsored debts as well.

Those who’ve funded their higher educational pursuits with government-backed loans, however, may want to think twice, for the following five reasons.

1. Credit Underwriting

Despite the fact that all education-related loans — public and private alike — are virtually impossible to discharge in bankruptcy (thanks to the successful lobbying efforts on the part of the financial services industry in 2005, atop an anti anti-establishment scheme that dates back to the mid-1970s), today’s private lenders aren’t taking that invulnerability for granted. And they shouldn’t. Not with so many consumer advocates who are calling for the restoration of the bankruptcy code with regard to this form of debt.

So unlike the federal government, which blithely continues to process loan requests as it has before, private-sector lenders are looking more carefully at a prospective borrower’s ability to service the loan he or she is requesting. Things like historical earnings, debt levels, leverage and credit scores. And when these aren’t enough (or too much, as the case may be), they’re asking for family members and others who are financially better situated to co-sign the loan.

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Pity the co-signer, though, when that occurs, because they will have a heck of a time getting out from under that responsibility, even after the primary borrower’s economic outlook improves to the point of self-sustainment.

2. Fixed Versus Floating Rate Loans

Also unlike the government-backed loan programs, some private lenders are tempting debtors with what amounts to low introductory-rate financing, much the same way that some banks and private mortgage lenders tempt other consumers with adjustable rate mortgages (ARMs).

In both instances, interest-rate risk is effectively transferred to the borrower from the lender. In other words, when rates move up, so will the amount of the loan payment. When rates move down, however, you may well find the payment amount will not decline below a certain point.

Certainly, there are those who are comfortable rolling this pair of dice. The question is, is it worth the gamble in the first place?

The average level of per capita student debt is roughly $35,000 as of 2015. At 2% interest — not an uncommon introductory rate — the monthly payment on a 10-year education loan amounts to $322. In contrast, that same loan would run $350 per month under the Federal Direct program, which charges 3.76% interest at present.

I don’t know about you, but I’m not willing to wager on the direction of interest rates for $336 per year.

3. Prepayment Penalties

And then there’s the matter of loan pre-payability.

Federal student loan borrowers have the right to pay off their debt in full or in part at any time, without penalty. That means, whatever interest the borrower would have been charged over the remaining term of his or her loan is waived when the debt is fully paid off, or discounted when the loan balance is reduced quicker than it otherwise would have been.

Not necessarily so in the private sector.

Depending on the terms of the refinancing agreement, the lender may require its borrower to pay a premium — a word that the financial services industry prefers to fee — to retire their loan ahead of time.

4. Superior Relief

Perhaps the key difference between public and private higher-education loans is the quality, quantity and active promotion of the relief programs that are available to financially distressed borrowers.

Setting aside for the moment the problems that the government is attempting to remedy with the loan-servicing companies to which the Department of Education subcontracts the administration of the student loans it originates, no other lender is as willing to accommodate both temporary and longer-term hardships than the federal government.

Whether you chalk that up to Uncle Sam’s sincere desire to assist troubled debtors or to protect the taxpayers who will ultimately be left holding the bag on this financing program, hands down, the government’s income-based, income-contingent and public-service debt-forgiveness plans are superior to all others.

5. No Going Back

Last but not least, there are no round-trip tickets when it comes to financing government-backed student loans that were refinanced by private lenders. Once these loans are off the government’s books — what happens when a loan that’s made by one lender is financed at a later date by another — they are no longer eligible to be refinanced under any of the government’s standard or distressed-borrower relief programs.

With all this in mind, while it could make sense to refinance existing education-related debts that were originated in the private sector — provided you’re not being asked to give up more in the form of co-signors, prepayment penalties and so forth in exchange for that consideration — it’s hard to justify refinancing your government-backed debts in this manner.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.

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