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Borrowers may not want to refinance federal student loans before the payment pause expires on Dec. 31, 2022. After all, refinancing federal loans with private lenders means resuming repayments immediately.
But with interest rates rapidly increasing and student loan forgiveness on hold, those planning to refinance soon need to prepare their finances. If you start now, you can work on paying down high-interest debt, improving your credit score and shopping for the best refinance offers.
How to prepare your finances for student loan refinancing
When you refinance your student loans, you replace your student loans with one private student loan. Unlike federal student loans, refinance lenders base eligibility and interest rates on creditworthiness and overall financial health. While some lenders offer refinance loans for those who have less-than-stellar credit or a low income, it doesn’t make sense to refinance without a better interest rate or terms.
There’s no one-size-fits-all approach to refinancing. However, following these steps may increase your chances of scoring better rates and getting approved.
1. Pay down high-interest debt
If at all possible, pay down high-interest debt before applying to refinance. Lenders base eligibility on a number of financial health factors. A major one is your debt-to-income ratio, which is your monthly debt payments divided by your gross annual income.
To the lender, your DTI indicates your ability to manage another monthly payment. The higher your DTI, the harder it’ll be to get approved. With a lower ratio, you are more likely to get approved and be offered the lowest interest rates. Generally speaking, lenders favor co-signers and primary borrowers with a DTI under 50 percent.
Before refinancing, check the DTI requirements on the lender’s website. Typically, this information is listed under “eligibility requirements” or within the terms and agreements document.
Then, calculate your ratio using a calculator or through a simple equation. Add up all of your monthly debt including mortgage, credit cards and other loans and then add up all of your monthly gross income. Divide the monthly debt by your income to reach your DTI percentage.
2. Improve your credit score
Improving your credit score is a great way to prepare for refinancing your student loans. Lenders want creditworthy borrowers, and your credit score is a primary indicator of your financial habits.
With the FICO scoring system — which most lenders use — a very good to excellent score is above 740. The average score in America falls between 670 to 739 and most lenders accept borrowers with these scores. But it’s likely that if your score is at or below the average, you won’t be offered the most competitive rates.
Generally, those with a credit score in the mid-700s and above stand the best chance of getting the lowest interest rates.
How to improve your credit score
Factors like whether you pay your bills on time, how many lines of credit you have, how long you’ve had specific accounts open and how much debt you have determine your score.
Improving your score happens over time, but some habits could result in a small jump quickly. For example, your credit utilization ratio — the amount of available credit you use compared to your overall limit — makes up around 30 percent of your score. Lowering your utilization ratio across all your cards and making your monthly payments on time are the fastest ways to increase your score.
Time is also a significant factor in growing your credit. If you have a thin credit history, you’ll likely need a creditworthy co-signer to boost your chances of approval.
How to check your credit score
If you have a credit card, you can likely check your score for free through your account portal on the servicer’s website. You can also check your credit report for free through one of the three reporting bureaus: Experian, Equifax or Transunion.
Due to the ongoing pandemic, you can get a free credit report weekly. Normally free reports are limited to once per year per bureau.
Your credit report records your credit score in-depth, cataloging every hard check, missed payment and account history. It’s crucial to check your report at least once a year to get a well-rounded look at your financial health.
If you notice a discrepancy or error in your report, dispute it with the reporting agency. Clearing up errors can help improve your score.
3. Shop around
When refinancing your loans, one of the most important things you can do is shop around. Every lender offers different requirements, repayment terms and interest rates. When you prequalify with multiple, you can compare lenders and find the right match for your needs.
Most refinance companies offer prequalification, allowing you to see your eligibility and predicted interest rate without applying. Prequalifying doesn’t impact your credit score like applying does and minimizes the risk of gaining multiple hard checks on your credit report.
If the lender offers minimal information on eligibility requirements and no prequalification tool, it may be best to choose a more transparent lender. Your goal for refinancing is saving money, and if you can’t guarantee that, applying likely isn’t worth it.
See if the lender offers fixed or variable interest rates. Due to inflation, the Federal Reserve has been hiking rates at record-breaking speed. Private lenders have raised their rates in response. If the lender you choose offers only variable rates — interest rates that are subject to change based on market conditions — your rates will likely continue growing as the Fed attempts to cool rising inflation.
Finally, consider financial hardship options, potential discounts and any other unique features the lender offers.
Should I refinance my student loans right now?
If you only have high-interest private student loans, consider refinancing as soon as possible. Interest rates are expected to continue growing. If you lock in the lowest fixed rate possible now, you can always refinance again once rates deflate.
If you have a mix of federal and private student loans and are considering refinancing, start preparing your finances now. It may be best to hold off until the federal payment pause expires on Dec. 31 so you don’t have to resume payments early. But if you’re currently making payments and have prequalified for a lower rate with a refinance loan, consider applying as soon as possible to lock it in.
Remember that you lose access to forgiveness programs and repayment benefits after refinancing federal loans. Research your federal benefits and the private lender’s relief programs to determine whether now is the right time to refinance your federal debt.