So we’ve talked about what interest is and how it works. Now, let’s talk about what happens when the magic power of interest is your enemy. Let’s talk about debt. We’re going to talk about why it can be so hard to pay that debt off and ways you can go about making your life easier. Since student loan debt is such a universal thing that’s going to be our focus for today. At the end of this post we have our testimonial about a student loan refinancing company we have personally used – Social Finance, Inc., or SoFi.
Student Loan Debt
Student loan debt can be crushing. When you’re in school you probably didn’t think about it much. It was $500 here for books, $10,000 there for tuition, $25 for lab fees (whatever those are about). Then you graduate, feel good about yourself for finishing, and then a month later get a nice note from your lender telling you how much you owe and that your grace period will end well before you’re ready. You do a double take, put on your glasses, shake your head, take a quick walk around the room, come back and yep, it’s still true… You. Owe. A. Lot. Of. Money.
You suck it up and decide to pay it because you are an adult and this seems like an adulty thing to do. Every month for the first year you send off a check or do an auto-draft from your account and you feel proud of yourself. At the end of the year you log into your loan provider’s account ready to oogle at your significantly shrunken debt. And then you look at the number and do a double take. The number looks barely any lower. What the heck is going on?
The answer is our old friend interest. Let’s take an example.
- For simplicity let’s say all your loans are at the same rate, 6%, and that you owe $50,000. We’re going to assume that interest is only calculated once per year and not compounded. You decide you’re going to pay $250 a month so over the course of the year you pay $3,000 towards your loan. What’s your loan amount at the end of the year?
- Principal: $50,000
- Interest accrued: 6% * $50,000 = $3,000
- Amount paid: $3,000
- Balance: $50,000 + $3,000 (interest) – $3,000 (payments) = $50,000.
Congratulations, you’re exactly where you started. *slow clap, sad face, super sad face*
Relax, it’s not quite so dire. In reality it doesn’t actually work this way for a few different reasons. You did make progress….it’s just really slow progress.
How interest is calculated
First of all, the interest isn’t calculated once a year but rather is calculated daily and it starts calculating the moment the loan is issued. So a 6% annual rate is 6%/365 days per year = 0.016% per day. This ends up being 0.016% of $50,000 = $8.12 of interest per day. Thankfully it isn’t compounded.
On January 30th you’ve accrued $246.58 (30 days * $8.12 per day). You make your payment of $250. $246.58 of that goes to interest and the remaining $3.42 goes towards the principal. That’s right. Three whole dollars. This is why it looks like you’ve barely made any progress. Over time the principal will slowly decrease so the daily interest you accrue will decrease and more and more of your payment will go towards the principal. It’ll just take a while.
Different loans, different rates
Second, most people have different types of loans at different interest rates. Now, to review, there are two broad groups of loans: public (or federal) and private loans. Federal loans can also be subsidized, meaning all the interest is paid for you until you enter repayment. All other loans are unsubsidized which means all interest you accrued while in school is added back to the principal when you graduate. It makes your loan bigger and it sucks.
So now you know more about how student loans work. Next, let’s talk about a way to manage them. Specifically, we’re going to talk about refinancing.
Refinancing is the process where a new lender pays your original lender the balance on your loans and then combines them into one new loan.
- You typically can’t refinance and combine federal and private loans (though some lenders can do this) though you can always refinance and consolidate one or the other (federal with federal and private with private)
- The new loan can have a different interest rate than the original loan and is usually based on your credit score.
So why would you want to do this?
There are two situations in which interest rates will be lower than when you first took out your loans.
The first is a macro issue and out of your control: interest rates overall are lower. This has been the case for the past several years.
The second factor is much more personal: you likely are in a better financial position now than when you took out the loans. Specifically, you have a significantly better credit score (50 points or more greater). This can enable you to qualify for a much lower interest rate.
Why do you want a lower interest rate? If you remember our example above, the lower your interest rate the less interest you accrue and the more of each payment goes towards the principal. This means you pay off your loan faster.
Another important, though initially less visible benefit, is that you can convert variable interest rate loans into fixed interest rate loans. To quickly review, fixed interest rates are just that: they are fixed over the life of the loan. Variable interest rates can rise and fall and are based off the overall market interest rate. Since interest rates are unlikely to go anywhere but up in the next ten years getting a variable rate converted to a fixed one now can be very valuable.
Why would you not want to do this?
- If you have a benefit with your federal loan such as public loan forgiveness you lose this benefit if you refinance.
- Some lenders charge an origination fee which is usually some percentage amount of the loan (2% is a common one) which they add to the balance of your loan. Avoid these.
- Some lenders don’t provide a 0.25% interest discount for setting up auto-pay from your checking account. Avoid these.
- Your school may not be eligible for refinance.
- The lender’s customer support is terrible. Avoid these as well!
So there you have it. A quick and dirty summary on student loan refinancing. It can definitely be a good thing and save you a lot of money in the long run. If you opt to refinance they are many, many lenders out there offering their services but be sure to do your leg work first and find one that you find valuable.
If you’re looking for recommendations, we’re big fans of Social Finance or SoFi for one simple reason: SoFi tends to be very selective about who they’ll refinance with and don’t include basic credit scores in examining an applicant. Healthcare workers (nurses, physicians, and pharmacists among others) tend to be among the people they choose.
Reasons to consider SoFi from our experience in refinancing with them:
- It’s a non-bank lender that is challenging bigger banks with their alternative approach to providing refinancing… Hello! That’s awesome.
- A very easy to use website: you create your account, put in your best guess for your loans and boom, you get a pre-approval or not.
- Ease of document upload: you’ll have to provide a digital copy of a loan statement, a pay stub and an ID. Luckily, you can just take photos of them with the SoFi app and upload them that way.
- Competitive rates: their rates are among the best around and they’ll show them to you right away without any run around. They offer different repayment lengths (the shorter the repayment length the better the interest rate) and will tell you how much your monthly payment will be so you can easily compare them.
- Great customer service: having gone through the application process with them I found that any email I sent was answered within 24 hours (often much sooner). Customer service is available 7 days a week.
- You can refinance federal and private loans.
- They offer an autopay discount of 0.25% off your interest rate (not all lenders do this).
- Members save on average, $18,936. Imagine what you can do with this!
- There are no origination fees or prepayment penalties (this is a big one! Who wants to pay a penalty for being awesome and finishing loan repayment early!).
- Unemployment protection: If you lose your job, they’ll temporarily pause your payments for six months and help you find a new job.
We really like them and we think you should give them a shot.