Student Loans: Consolidating vs Refinancing - Part 2

Student loan refinancing is different than consolidating your student loans.

Consolidating your student loans, as I mentioned in our prior module, is when you simply bundle all of your loans into a single or at least a portion of them, could be all or some into a single direct government loan. Now refinancing is different. Refinancing is taking out a brand new loan with a private bank that is not the government at a market determined interest rate, in other words, not a government determined interest rate, a market determined interest rate, just like a home mortgage. And it's going to be used to then pay off your government backed student loan. So that bank will cut a check or wire money, they'll send it to the federal government and the federal government will say your loans are now paid off, but now you have an obligation with this bank to pay them off based on the terms set with that bank. And when should you not when you should refinance is a really important decision. You gotta be extremely careful to not jump into a refinance too early because generally what happens is that your payment goes up when you move to a private loan. Because now guess what, your payment isn't limited to 10% of your income like an IDR plan. Therefore payments can go way up. But there are benefits. I'm going to explain those benefits and why. Refinancing may be a great decision at the right time, but when it comes to timing, you want to keep your student loan payments per month as low as possible until you get through a few events in your life, in your career. And I explain this in the overall timeline of events, so I'm not going to go into details, but basically you want to keep that as low as possible when you buy your practice, and even possibly the building for your practice and buy your home. Because what the banks are going to look at is called your global debt coverage ratio. And your global debt coverage ratio is simply how much of your income is going to have to go toward paying all of your debt obligations every month. And the bank will only allow a certain portion of your income go to pay off your debts. And so if you keep your student loan payments low enough, then that frees up more room to pay other debt, such as a practice acquisition debt or a home loan debt as well. So once you buy the practice, you buy your home, and now really, we don't need to have.

Lower overall debt coverage ratio, I mean a lower payment structure in all of our debts, then it's probably okay to assume a higher debt payment on your student loans by converting them to a private loan. So that's important on the timing. If you refinance too early and now you're paying $4,000 a month on your student loans and you're locked into that, and it's going to be more difficult for you to get a practice purchase loan because the bank doesn't just look at the practice cash flow. They're also looking at what your personal.

Debt obligations are, such as a car payment and student loans. All right, a few things I want to emphasize when it comes to refinancing with a private bank, your student loans is that number one, the private loan interest rates tend to be a lot more favorable. They tend to be very low. Now, market determined rates are always fluctuating. I mean, by the day these things are fluctuating. But typically they're lower than what the federal government's student loan rates are. Right now I'm seeing somewhere around 2.75, up to maybe the high threes or, or low fours for a fixed loan.

And the reason why they can be lower is that the government doesn't look at your credit score when they're lending you money to determine their interest rate. They're just giving everybody the same rate. Banks, however, will look at you as an individual, as an individual with different financial behavior than the next person, and they'll look at your credit score. And so if you have a healthy credit score and you're showing healthy financial decision making in your life, then they're going to be willing to keep that rate lower because your risk of paying them back, of not paying them back is lower. You're a lower risk borrower. The terms on these loans are typically five to 15 years on private loans. And of course, if you do a five year loan, your payment is going to be a lot higher. But guess what, your interest rate is going to be a lot lower. Because remember, the bank's always looking at risk and there's a lot more risk when they have to wait 15 years to get a loan, their loan fully paid back versus only waiting five years. So the interest rate goes down on the shorter term. A 15 year rate is a 15 year loan interest rate is going to be higher than a five year loan interest rate. However, the payment on a 15 year.

Loan payment, even if the interest rate is a solid one 1.5% higher than a five year loan, you're still going to pay a lot less on that 15 year mortgage because it's spread out over 15 years as opposed to 5 years. I commonly see somewhere between maybe 7 to 10 years on your student loans. But I've also seen reasons why it might be better to go at 15 years or even accelerate to five years. And there's a little bit of personal financial planning preferences and your own psychology around debt that can play into it as well at some level. Now, the last thing I want to mention here is underwriting guidelines tend to be pretty strict where the federal government will basically give you money because you're breathing and you're in school. Banks are very different. They will lose money if you don't pay them back. And so they do their due diligence, and that's called underwriting. And when they do their underwriting, they're going to look at your credit score, as I mentioned, and various other factors to determine whether you are a good candidate to take their money. And so they're going to sometimes require that you have some what's called liquidity, which is simply some cash in a savings account or some in maybe some money that's in an investment account would be considered liquid, meaning you can access that if you needed to. And some banks will even require First Republic, which does a lot of these loans as of 2020, they like to see 30%.

Of the balance or of the loan that you have in cash. So if you have a $200,000, let's say a $300,000 loan, they're going to want to see $90,000 in cash. Now, that's a tall order for some people. And you may say, well, I would just pay off my student loans if I had that. Well, maybe, maybe not. There's other reasons to have liquidity. But I'm always telling, I'm going to tell you early on, try to set a little bit of money aside every month into a savings account as an emergency reserve, because that emergency reserve can double as liquidity requirements when you're going to apply for a loan such as a student loan refinance or a home loan. And that can be very valuable for you as a borrower. Let's now talk about a couple other factors here. And there's four unique factors I want to emphasize when it comes to refinancing your student debt. The first one is that once you cross that bridge and you refinance with a private bank, there is no going back, period. No more IDR, no more 10% cap of your income going to student loans. You've burnt the boats and stormed the beach. You're in it now and you got to stay in it. And these loans can be less flexible than a. In fact, they pretty much always are less flexible than a government direct loan. So make sure it's the right timing that you're in a good, healthy cash flow situation.

Next is there is a reduced statute of limitations. The statute of limitations is simply how long of a period of time before somebody can come after you for having not made payment on your student loans. And statute of limitations, I'm sure you know, applies to a lot of other areas of finance and litigation. But when it comes to student loans, it's how long basically before somebody loses their ability to come after you legally for payment on the student loans. Now, now, direct loans with the government, there is no statute of limitations that ends. It's always there. The government can always come for you 20 years down the road. But if it's with the bank, then standard banking statute of limitation rules apply, which means in some states, if you don't pay for three years and the bank never knocks on your door after the three years, it may be very difficult for them to collect because the statute of limitations is up. Some states it's 10 years, varies by state. Now, I don't want any of you defaulting. I want you to be, I want you to do the right thing. Let's plan on getting out of debt. But if you ever fall into that context, might be helpful to know number three is that the limits on these student loans can be very different by the lender. Some banks will allow more than others. Some might only allow you to take out a debt of 100,000. If you got 500,000, you're thinking, well, Wes, that's not very helpful. There's some truth to that. Other banks will go up to 300,000. Other banks might even do more than that. And that's per borrower. And so what you may have to do sometimes, this is not uncommon, is take 300,000. If in the case of, for example, First Republic, as of Today, they're doing 300,000 as their cap per borrower, and take the 300,000 and you refinance those higher rate direct loans that you have with the government. If they're not consolidated, or if it is consolidated, you pay off 300,000 and the rest stays with the federal government. This isn't all or nothing. Just like when you consolidate, you don't have to consolidate all of your student loans into a single direct loan. Same thing when you refinance with a private bank. You don't have to refinance all of your student loans. You can refinance some of your student loans. And so you do it up to 300,000. Then as you pay that down, perhaps you create space to then refinance more of your consolidated or your federal student loans. And the last comment is that these loans are almost always not forgiven. When you move into private, they will follow you, typically to the grave. So if you become disabled or if you die.

Even if you're disabled, you still got to figure out a way to make that payment. If you die, then your estate typically will have to if there are assets in the estate, they're going to be attached to make that payment. Now, some banks have some leniency around these, but other banks may require that you take out a life insurance policy or have make sure you have a disability insurance policy in place so that they can be made whole in the event that one of those two unfortunate events occurred in your life. And we have created a resource, and it's on our Resources page on the Associates on Fire website, and it has a grid of some of the more common student loan lenders. And it compares different features about those student loans, maybe how much they lend, what their interest rates are, and some unique characteristics about their lending profiles and guidelines. Consider that a resource for you. We encourage you to use that. I hope now that you have a better idea of consolidation with the federal government versus refinancing with the private bank, when might be the right decision for each of those and the sequence of events leading to a good sort of flight path through your student loan experience.