Following months of increasing pressure from the federal government, more private lenders are beginning to offer options for borrowers to refinance their student loans at lower interest rates.
In the last month, two of the largest private student lenders – RBS Citizens Financial Group, which operates both Citizens Bank and Charter One Bank, and Discover Financial Services – have announced that they will give borrowers the option to consolidate and refinance their student loans. Unlike federal student loans, private loans typically come at a higher interest rate and have less flexible repayment options.
Due to those complications, many private student loan borrowers struggle to make their payments and often end up defaulting on their loans. According to an estimate from the Consumer Financial Protection Bureau, as many as 850,000 private student loans – worth a total of more than $8.1 billion – are in default.
"Things certainly change from what you think might be the case when you go to school and the type of job you get when you come out," says Brendan Coughlin, head of education and auto finance for Citizens Financial Group. "We just didn't feel our product was complete to meet our customers’ needs without offering them this ability."
Because many private student loan borrowers take out their loans when they have no degree and no job, lenders take into account the risk that a borrower won’t graduate or won’t get a job when they set their interest rates. But many private student loan borrowers took out their loans when interest rates were high and the private student loan market was booming in the early 2000s.
"What we've seen over the period of the last several years is interest rates have declined, and borrowers haven’t been able to graduate and get a job, but they’re unable to take advantage of today’s historically low interest rates, as well as their improved credit profile," says Rohit Chopra, the CFPB's student loan ombudsman. "So a number of borrowers have double-digit interest rates and are looking to find a lower rate."
Still, Mark Kantrowitz, senior vice president and publisher of Edvisors Network. says it isn’t ideal for recent graduates to seek refinancing options. In fact, he says it’s the worst time to do so because private student loan refinancing, unlike that of federal student loans, depends heavily on a borrower’s current credit score.
The typical pattern, he says, for private student loan borrowers is that credit scores will drop each year they’re in school. That also means each new loan they take out while in school will carry a higher interest rate.
"By the time they graduate, their credit score is at its lowest point and their interest rates are at their highest point," Kantrowitz says. The best time to look into refinancing private loans, Kantrowitz says, is a few years after graduating. Because recent graduates often start out with thin or nonexistent credit histories, young borrowers can often quickly improve their credit scores with consistent positive credit activity, he says.
"That means never late with a payment. Too often I hear from borrowers who say, 'But I was only late with one payment,'" Kantrowitz says. "Well, one payment is enough to ruin an otherwise good credit score."
Still, there hasn't been much activity in the private student loan refinancing area because capital markets – those where debt is bought and sold – are still in recovery following the credit crisis that began in 2008, Kantrowitz says, and lenders lack the capital they need to make new loans. But pressure from government agencies such as the CFPB – which last May called for an expanded refinancing market after analyzing 28,000 public comments – and officials from the Obama administration may be partially prompting more banks to get in the game.
Ideally, refinancing private student loans should be a "win-win proposition" for lenders and borrowers, Kantrowitz says. But lenders are sometimes hesitant to offer refinancing options to responsible borrowers who consistently make on-time payments, for fear of losing interest revenue.
"The only reason why you would do it is as a defensive posture because if you don't do it, someone else will," Kantrowitz says. "But if there isn't a healthy refinancing market, you don’t need to do it because nobody else out there can afford to do it either, even though it's profitable."
To refinance a private student loan, a lender will consolidate all loans into a new one at a lower interest rate, and use that loan to pay off the original loans. This can be done through the original lender, or through another entity that offers refinancing. That's why a growing refinance market may encourage other lenders to follow suit, so they don’t lose customers.
"Many lenders who currently hold high-rate private loans may be reluctant to offer refinance products since it may hurt their own bottom line," Chopra says.
Until recently, just five private lenders have offered refinancing options widely – both to their own borrowers and those who took out loans from other groups, Kantrowitz says. So adding two more options for borrowers, although it may not sound like a lot, is actually a big increase in the marketplace, he adds.
"Before the credit crisis, there were only a dozen," Kantrowitz says. "It's never been a really large marketplace, but there's a lot of consumer interest and borrower interest in refinancing private student loans, because they're starting to see the interest rates increase, and that’s got them concerned."
But Chopra says more financial institutions, particularly credit unions, are getting into the refinancing game when banks are hesitating.
"They see it as an important way to build relationships with customer that over time can perhaps lead to that customer taking out a mortgage, opening up a bank account, and essentially generating revenue for that financial institution over their entire financial life rather than just from their student loan," Chopra says.
But borrowers' motivations for which refinance option they choose vary widely, Coughlin says. Some students want to extend their payment terms and have lower monthly payments, while others may want to increase their monthly payments to become debt-free more quickly. That's why Coughlin says Citizens Financial Group chose to offer both fixed and variable loans, with rates as low as 4.74 percent and 2.4 percent, respectively.
"The overall consumer need for [refinancing] … has been lost a little bit in some of the dialogue in recent days," Coughlin says. "But if you compare it to other loan products, it's not too dissimilar than how consumers think about refinancing their mortgage and other products like that."
Depending on how borrowers choose to refinance their loans, it can have a number of positive effects, Chopra says.
"It can help them improve their credit profiles so they’ll
be able to qualify for a better rate on a mortgage or auto loan. It may free up
cash flow to save for retirement or start a small business," Chopra says. "We’re
seeing that as we've raised this issue repeatedly, that the market is
definitely responding with a number of new products for these borrowers."
Corrected on Feb 19, 2014:
previous headline of this story implied the Citizens Financial Group refinance
option was a direct response to government pressure.