I’ve refinanced mortgages more times than I can easily count. Each time, I willingly paid another set of closing costs in return for a lower interest rate.
And I’ve never regretted it!
How could reducing your interest rate ever be a mistake?!
It Isn’t All About Interest
Taking a 30-year mortgage at, say, 6 percent interest, you’d end up paying more in interest than the original balance.
For example, a $500,000 loan at a fixed 6-percent interest ends up costing $579,191 in interest charges, nearly 16 percent more than the original balance!
If you could refinance that to a 4-percent loan, even if you pay $5000 at closing, saves you over $200,000 over the 30-year life of the loan.
For shorter-term loans, things aren’t as dramatic…
Take a $20,000, five-year auto loan at 5 percent — your interest cost is $2645. Refinance to a 3.5-percent loan and you’d save just $630, barely $10 a month. If that required you to shell out much money (or even spend a lot of time), it may not be worth it.
But according to Michael R. Acosta, CFP®, ChFC®, Financial Planner at Consolidated Planning, auto loans aren’t really his biggest concern for clients.
No. It’s student loans, and here’s why.
The Problem with Refinancing Student Loans
Acosta says, “When it comes to student loan planning it isn’t as simple as chasing the lowest interest rate. Too often I find clients were advised to refinance from federal to private loans, but had no idea of the irreversible change that causes.
- “Loans don’t necessarily get discharged at death, unless it’s specifically stated in the private lender’s promissory note
- “Loans don’t necessarily get discharged due to disability, unless it’s specifically stated in the new promissory note
- “A co-signor is often needed to be approved for private loan refinance, putting someone else at risk in addition to you should you default
- “Private loans have only a fixed standard repayment schedule, so you lose the option for flexible income-based repayment
- “You lose any forgiveness options you might have had with a federal loan.”
Acosta continues, “Defining the most efficient repayment strategy is more complicated than you’d think. You have to consider what you’re looking to achieve over the course of the next seven to 10 (or more) years.
“You need to consider the opportunity cost of paying down your loan aggressively vs. seeking ‘time-based forgiveness’ or ‘public-service loan forgiveness,’ and the potential wealth you might lose over that time.
“Keep in mind that from the moment you complete your training or graduate, the next 10–15 years of your life will likely comprise many milestones, e.g., getting married, starting a family, purchasing your first home, updating your car(s), possibly moving across country, etc.
“If you throw everything including the kitchen sink at your student loans, trying to pay them off as quickly as possible, you forgo the opportunity to grow your assets. That will likely delay your ability to achieve the above life-cycle milestones.”
I asked Acosta for a concrete example. He was happy to oblige…
A Student Loan Case Study
Acosta brings up a hypothetical (but not unusual) case — a general dentist who just graduated and is starting her first year at a dentistry practice.
“Take for example a general dentist coming out of residency with $400,000 in federal student loans.
“She might start her career making $200,000 pre-tax. That $400,000 outstanding debt can create real anxiety and stress because it’s hard to see the light at the end of that tunnel.
“If she comes to us, we can illustrate for her what things would look like with time-based forgiveness and/or using an income-driven repayment plan vs. refinancing the full $400,000 to a private loan, even at lower interest.
“If she chooses the forgiveness option, that initial strategy isn’t carved in stone, and can evolve over time based on her career’s progression.”
The thing is, most dentists don’t start making “real money” until they start their own practice.
Acosta explains how that can work out, “If you want to own or buy into a practice, you need access to capital. You can do this by either building liquid assets (harder) or taking out a healthcare loan to fund the purchase.
“If you’d already refinanced your student debt into private loans, your monthly payment may be too high to get approved for the new loan. You simply don’t have many options to reduce private student-loan payments. Your only hope at this point is to try and refinance again with another private lender offering a lower rate. The problem is that this might reduce your payment very little, possibly not enough to qualify for the loan you need to finance buying (into) the practice.
“If you’d kept your higher-interest federal loans and gone into an income-driven repayment plan instead, we could be strategic with how we allocate your annual gross income (AGI). We can, e.g., max out your pre-tax retirement contributions, max out your health-savings-account (HSA) contribution, contribute to a dependent care flexible spending account (FSA), and/or take advantage of other cafeteria benefit options to reduce your AGI.
“Reducing your AGI lets us reduce your required federal-student-loan payments. That then looks better to the underwriter for the new loan you want to take out for buying the practice.
“Once you’ve purchased the practice, assuming you make a go of it, you can take future K-1 distributions to make lump-sum payments toward your federal loans, paying them off much sooner than you’d have expected.”
The Bottom Line
On your own, you might not realize that refinancing your federal student loans to a lower-interest private loan could lock you out of the most lucrative opportunity — buying your own practice.
Depending on your specific situation, something like that may or may not become an issue. A financial planner can help you consider things from more angles, and potentially suggest a counter-intuitive path that might work out better for you.
Acosta sums it up, “At the end of the day, borrowers want advice that offers them flexibility but also helps them see the finish line. I‘m not opposed to them paying student loans back sooner rather than later, paying less interest. I just want them to know all their options, because many don’t have all the information when it’s time to make a decision.”
This article is intended for informational purposes only, and should not be considered financial, investment, business, tax, or legal advice. You should consult a relevant professional before making any major decisions.