According to a recent NerdWallet household debt study, dentists and doctors have some of the highest student loan debt balances compared to other types of professionals. At any income level, managing a six-figure debt load can be very difficult. To further complicate the matter, many doctors and dentists already have a late jump on saving for retirement and other goals by the time they enter the workforce, so managing monthly student loan payments is especially important. Given today’s ultra-low interest rate environment, there’s a unique opportunity for some professionals to refinance their student loans.
How are student loan interest rates determined?
Interest rates on federal student loans are set each May based on the 10-year treasury. The rate is fixed, so while new borrowers may benefit from lower rates for the next academic year, today’s low rate environment won’t change anything for existing borrowers of federal loans, unless they choose to refinance into the private market.
Private education loans can be variable or fixed and are often tied to 1-Month LIBOR rates. Outside of the current rate environment and economy, the exact terms a borrower may be offered will depend on their personal financial situation: credit history, income, loan program, and even their profession or degree can all influence the quoted interest rate.
The Federal Reserve’s recent decision to cut interest rates in response to growing concerns about the economic impact of the coronavirus could be favorable for borrowers. While the Federal Reserve does not set interest rates directly, the Federal Funds rate (which is a suggestion of what banks should charge each other for overnight lending) tends to move in the same direction as the 1-Month LIBOR and the Prime Rate, which is another key interest rate benchmark.
Source: ICE Benchmark Administration Limited (IBA), 1-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar [USD1MTD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD1MTD156N, March 6, 2020.
The notable exception here is in 2008, when economic uncertainty and the financial crisis resulted in a sharp spike in the 1-Month LIBOR for a period of time. Given the recent volatility in the financial markets, further consideration is warranted if you’re considering a variable rate loan.
Student loan refinancing strategies
Like any financial decision, it’s important to do your homework and investigate the options and risks before moving forward.
Shop around: As with any loan, you’ll want to speak with multiple lenders to get the best rate and terms for your situation. One of the biggest mistakes borrowers make is assuming rates are the same everywhere. Many lenders have specific underwriting criteria they’re looking for and only offer the best terms to those borrowers. Doctors and dentists tend to be sought-after customers for lenders, so it’s worth keeping an eye out for special programs.
Consolidate or refinance? Much like when you refinance a home, when you refinance student loans your existing loan is paid off by the new lender and you begin payments on a new loan with a lower interest rate and possibly different terms. This is generally done by taking federal loans and moving them to private lenders. When you consolidate federal loans with a Direct Consolidation Loan, all the loans are rolled into one and the interest rate is the weighted average of all the loans. The loans stay with the federal government. The benefit is simplification more than anything, but borrowers may inadvertently sacrifice flexibility in doing so, such as only refinancing loans with the highest rates.
Timing is everything, but you don’t have to do it all at once: As mentioned above, you don’t need to refinance all your student loans at once or even at all. If cash flow is tight, it may make sense to consider starting with loans with the highest interest rates. Depending on your other financial goals and career plans, timing could be a bigger factor. If you’re starting a business or buying a practice, refinancing may tie up needed cash flow, ding your credit, or tighten debt-to-income ratios with higher monthly payments.
The best rate that works for your finances: When you refinance your student loans, you’ll have options to weigh. Generally, the longer the loan term, the higher the rate. If you currently have federal loans, you may need to accept a shorter repayment period in order to refinance with a private lender. Repayment periods usually range from five to 15 years, though some lenders offer 20-year repayment periods. Depending on the terms of your current loan, this could substantially increase your monthly payment, even with a multi-point reduction on your interest rate. As you consider the term that works best for you, be careful not to sacrifice too much financial flexibility in exchange for a more favorable rate as it could put you in a precarious situation if your circumstances change.
Prepay vs refinance: Depending on the details of your financial situation, the optimal strategy for managing your student loans may be some combination of refinancing and prepaying certain loans. Though prepaying existing loans won’t lower your interest rate, it will help you save on interest expenses over the life of the loan. Since refinancing usually means changing your monthly payment, prepaying loans instead or in addition to refinancing can help give you flexibility. There’s no one-size-fits-all approach, which is why it’s important to work with your financial advisor and run the numbers for your situation and goals.
What you need to know before refinancing your student loans
Refinancing isn’t right for everyone. As you weigh your options, make sure you understand how refinancing impacts your eligibility for certain benefits only available for federal borrowers. Some of these safety-net programs include loan deferment, forbearance, student loan forgiveness, income-based repayments, and discharge at death or disability.
There’s no going back once you refinance with a private lender, so assess your risks and weigh the benefits with the potential cost and availability of other solutions. For example, perhaps you carry additional life insurance early in your career to match student loan liabilities.
Also pay attention to the terms offered by private lender. For example, you’ll want to ask whether there’s a prepayment penalty and a limit on refinancing again. Unless you plan on paying back your loans fairly quickly, it may not make sense to go with a variable rate if you could lock in a lower fixed rate. If you do want to refinance with an adjustable rate loan, ask about how rates are capped and options for refinancing variable rate loans.
Today’s low interest rate environment presents unique opportunities for borrowers and buyers alike. Though rates have been relatively low over the past decade, there’s no way to predict what will happen in the future. Borrowers should run the numbers and work to determine a threshold rate (if any) where refinancing makes sense for their situation.