MarketWatch.com, February 4, 2014. Discover Financial Services — one of the country’s largest private higher-education lenders — will soon begin offering consolidation loans to student-loan borrowers who want to refinance their debts. The company joins Wells Fargo, SunTrust Banks and RBS Citizens Financial, in doing so.
In fact, I recently received an email from a borrower who was questioning an unsolicited offer to refinance his private student loan debt that he’d received from one of these institutions.
There’s certainly a need for the service. According to the most recent Federal Reserve Bank of New York quarterly report, nearly 12% of student loan balances were 90 days or more past due — more than any other type of household credit.
And the 90-day figure doesn’t even take into account the fact that only about half of all student loans are actually in repayment mode. Nor is there any mention of the loans that have been forbearances and other accommodations, which leads me to believe that they’re no longer considered delinquent. Moreover, we’re only counting from 90 days past due instead of from the time the first payment was missed. All these things considered, troubled loans may constitute somewhere around 50% of the debts that are currently being repaid.
The Pathway to Student Loan Relief
So the $1 trillion question is, how helpful will refinancing be?
Financially distressed borrowers need help with their monthly payments. Given that there are four elemental components to most transactions of this type — principal, interest, term (duration) and payment — one or more of these variables will have to give in order for one or more of the others to change.
In this case, there are seven different ways to lower a payment amount:
1. Forgive a portion of the principal and keep the rate and term the same.
2. Reduce the interest rate and keep the principal and term the same.
3. Extend the term and keep the principal and rate the same.
4. Forgive a portion of the principal, reduce the rate and keep the term the same.
5. Forgive a portion of the principal, extend the term and keep the rate the same.
6. Forgive a portion of the principal, reduce the rate and extend the term.
7. Reduce the interest rate, extend the term and keep the principal the same.
Let’s eliminate the principal forgiveness alternatives (1, 4, 5 and 6) because, when you think about it, what lender would want to enter into a loan on which it would knowingly take an immediate loss?
The same goes for adjusting downward the rate of interest (2 and 7), unless the rate at which the loans that are to be refinanced is higher than the refinancing rate that’s being proposed. (In that regard, borrowers should pay close attention to the annual percentage rate of any prospective refinancing because the calculation takes into account interest and fees.)
That leaves extending the term (3) as the most viable solution for reducing the payment. That is, provided the new rate doesn’t counteract that effect, which may be an issue because longer loan durations command higher rates.
Even so, I worry that the banks won’t be all that accommodating when it comes to refinancing uncollateralized loans for long enough durations to make a meaningful difference. I’m also concerned that borrowers who are already struggling with past-due payment problems will have trouble getting approved. Those who do get approved, however, should carefully review the loan agreement for two conditions in particular.
The first has to do with the interest rate. It’s important that fixed rates and the indexed spreads for variable-rate loans will not be subject to change unless the borrower is formally declared to be in default. A missed payment here or there shouldn’t have the potential to undermine the economic rationale for undertaking the refinancing in the first place.
Second, borrowers should ensure that they have the right to prepay their loans at any time — in whole or in part — and without penalty, so that they may limit the amount of interest that’s paid over the life of the loan.
According to the terms of the offer sent to the student-loan borrower who recently contacted me, the interest rates — variable and fixed — as well as the term of the loan are both conditioned on the creditworthiness of the applicant and that of the loan-cosigner the bank required. There was no mention about changes to these rates in the event of a missed payment, caps on the variable-rate loans, or the ability of the borrower to prepay the financing at any point. All the more reason to pay close attention to the terms and conditions.
Look, it’s possible that the private lenders may be able to help refinance some portion of these debts. The best solution, however, would be for the government to address this crisis on a direct basis by permitting the refinancing of all loans under its existing relief programs, without regard for type, origination source or past-payment performance.
Now, that would really make a difference.