The Student Trap

Logan Murray

NOT ALL DEBT IS created equal—and that’s especially true when it comes to student loans.

For the vast majority of debt, we can calculate the ongoing monthly payment if we know the interest rate, number of payment periods, current balance and if the payment is due at the beginning or end of the period. But for federal student loans, we may need to know one more variable: the borrower’s discretionary income.

With federal student loans, there are different income-driven repayment (IDR) plans, each with its own a method for calculating loan payments. But all of these plans base their payments on the discretionary income of the borrower, and potentially his or her spouse.

I want to emphasize federal loans here. What if you refinance your student loans with a private company, as some loan websites encourage you to do? Gone is the federal government’s income-based payment plan, with the flexibility it offers, and the standard debt rules will apply.

My advice: Think long and hard before you follow advice—often provided with a convenient link to a private student loan lender—to refinance with a private company because it’ll lower your interest rate and purportedly save you money over the life of the loan. The decision has aspects that go far beyond the loan’s interest rate.

Student loans are extremely complicated and nuanced, and each individual’s circumstances need to be considered. What if you go ahead and refinance with a private lender? Once it’s done, it is irrevocable. No take-backs.

Here are some of the perks that federal student loans offer, which borrowers give up when they choose to refinance with a private lender:

Loan forgiveness. Federal student loans on an IDR plan can be forgiven after 10, 20 and 25 years, depending on the type of employer you work for, as well as the IDR plan used.

Income-based payments. Federal student loans have flexible payment options that allow for a change in monthly payments due to a change in income. By contrast, private student loans operate on a set repayment schedule.

Payment freezes. Private companies can choose to pause payments, and many did at the start of the pandemic. None, however, has suspended payments for the two-plus years that the federal government has offered through May 1. Federal loans also include the flexibility to pause payments for changes in individual circumstances, such as going back to school, changing jobs, encountering financial difficulties and more.

Uncapitalized interest. Student loans operate with simple interest. That means interest accrues on the original balance of the loan. In certain situations, individuals on an IDR plan have more interest accruing each month than they’re paying, so their debt is actually growing larger. Refinancing will capitalize that full amount, including the accrued interest. The interest rate may be lower on the private loan, but it would be applied to a higher loan balance.

Future policy changes. There’s plenty of speculation in Washington surrounding federal debt cancellation and the introduction of a friendlier IDR plan. Private loans are not likely to benefit from any such policy changes.

The bottom line: “Experts” should think carefully before blithely recommending refinancing federal student loans with a private company. It’s a classic cost-versus-value discussion. Refinancing may save you money in the form of interest payments, but cost you the flexible terms you get with federal student loans.

Usually, securing a lower interest rate is the sole goal of refinancing. Not in this case. Make sure you understand the benefits you’d be giving up—permanently—before deciding what to do.

Logan Murray is a solo financial advisor. His company Pocket Project offers subscription-based financial planning services to young professionals. For more financial insights, check out Logan’s blog or connect with him on LinkedIn. His previous articles were Year-Round Planning and  COBRA Call Option.

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