What’s your “current” interest rate?
Borrowers who are considering a refinance often compare the “printed” rates of their loans to the rates available from a possible refinance, without realizing that their actual current interest rate could be much lower than the printed rate. This can occur when low payments, for example while on Income Driven Repayment (IDR) plan, are too low to cover the accumulating interest. Many physicians with substantial federal student loan debt, especially those still in training, are on an IDR plan because they are either aiming for Public Service Loan Forgiveness or because it’s the only way to afford payments. But as interest accumulates, their interest RATE goes down. How?
You don’t get charged interest on the interest
Federal students loans are unlike other types of debt in that the interest is not capitalized except in certain circumstances. This means that your unpaid interest is not costing you anything. You still owe it, of course, but it represents “interest-free” debt. For example, consider an initial balance of $200,000 at 5%, which now has accumulated unpaid interest of $30,000. Although you owe a total of $230,000, interest only accumulates at $10,000/year. That’s an effective rate of 4.3% (e.g. $10,000/$230,000).
An example, with visuals
Assumptions: The graph shows the actual or effective interest rate over a 10-year period on various payments plans. This assumes one consolidates federal loans upon graduation and is making $0 payments in the first year, then has a starting intern salary of $60,000 during a 5-year training period with small raises along the way, followed by an income of $200,000 after training.
The PAYE line is smooth, because the total interest is gradually increasing (and thus the rate decreasing) over time. But what’s going on with REPAYE? REPAYE has a feature where half of any unpaid monthly interest is immediately waived. The lower the payments and the higher the interest, the greater the interest subsidy. As income grows payments increase and eventually cover all of the interest, which is when the REPAYE and PAYE plans “meet”. The stair-stepped pattern to REPAYE represent the small raises one might expect during training.
What if extra payments are made along the way? They go only towards the interest and the net result is actually an INCREASE in the effective rate, with no net savings. Instead, any extra money one has should go elsewhere (interest earning savings account, retirement accounts, etc) until one chooses to refinance or otherwise has a lump sum available with which to pay off all the interest and a significant amount of principal.
It’s clear that one cannot simply use the 7.5% rate as a reference when considering a refinance. Remember that upon refinancing, your current loans are paid off, and there is a new loan. The new interest rate is now applied to the entire balance (principal+interest of the previous loans).
Use our refinancing calculator!
We have a cool little refinancing calculator where you can calculate your effective interest rate and compare it to a private refinance loan you are considering. It will show you your interest savings with a refinance (if any!) and also calculate how much your cash flow will go down after the refinance
Hopefully this makes sense, and you understand how interest works on federal student loans. But if not, ask us a question on our forums!