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I have about $30k in student loans. I graduated last May and have a steady income. Now, my company's credit union offers $3.5k loans at 3% to be repaid over a year (they automatically deduct from my check).

I am considering taking out one or two of these to knock out some of my higher interest loans, which can be between 7% - 9.5%. Is this a good idea? Are there any drawbacks?

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up vote 10 down vote accepted

One drawback worth keeping in mind when you are doing the math to figure out if this is worth it or not is that the interest on a student loan is tax deductible whereas the interest on the loan from your credit union is probably not.

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3  
a tax deduction is worth maybe 30%, bringing his 7% interest down to an effective 4-5%, still higher than the 3% loan – james turner Jan 28 at 22:32
    
It would depend entirely on his income bracket and other factors like number of dependents. It's possible that the deduction really wouldn't be worth anything if he is already getting a full refund. – Kevin Jan 29 at 14:45

If your goal is to pay off your loans early, you don't have to refinance. You can simply pay extra on your student loans, making sure that any extra you send in is applied to the principal of your loans.

Refinancing the student loans into a new loan will save you money on interest, but over one year, it may not be a lot of interest.

Let's look at the numbers for taking two of these loans ($7k). For the sake of discussion, we'll assume that the average interest rate for these "higher interest" loans is 8%.

If you left the loans where they are and paid off the $7k in a year, it would cost you $307 in total interest. If, instead, you refinanced the $7k at 3% and paid them off in a year, you would only be charged $114 in total interest, a savings of $193.

Whether or not the refinancing paper work (and any fees) are worth the amount you will save is up to you.

The only other watchout I can think of when it comes to refinancing is that when you compare options, make sure that your new loan is paid off in the same time as the old loan would have been (or quicker). If you refinance at a lower rate, but take longer to pay off the loan, you would likely pay more interest despite the lower rate.

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Also pay attention to any origination fees. For smaller loans I think they're pretty rare, but if you have to pay $200 in fees that's not going to be a great idea. – Wayne Werner Jan 28 at 19:55

The potential drawback of paying off a long term loan with a short term loan is an increase in the required payments. That means you build up savings slower and if you lose your job you burn your savings faster.

You say this loan is to be repaid over a year. Thats a really short term. If things go well you would save a little bit of money verses just making bigger payments on the high interest loan but if things go badly and you lose your job but still have to pay the loan your savings burn rate will be massively increased.

It does depend on the exact terms of the loan though, if it's like a credit card where failing to make required payments or running off the end of a teaser period results in a massive interest rate hike then don't touch it with a bargepole.

On the other hand if there are some terms in there allowing for defferal in the event of losing your job it may be more worthwhile.

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If these are Federally subsidized student loans (Stafford, Perkins), then be aware that refinancing to a non-subsidized loan carries the risk of removing the flexibility you have to repay federally subsidized student loans, if something changes in your life (you lose your job, for example). With Federally subsidized loans, you have options to modify your payment schedule substantially in order to avoid defaulting on your loan if your circumstances change. Those are often not options for other kinds of loans.

For smaller amounts like this that may not be a high risk for you, but it's something to keep in mind; life circumstances change, health issues or job loss can make it harder to pay your loans off.

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On the other hand you're trading a debt that can't be eliminated through bankruptcy for one that can, which largely negates any concerns about being unable to pay it. – R.. Jan 29 at 3:02
    
@R.. Don't know about you, but I'd rather avoid bankruptcy... – Joe Jan 29 at 11:55
    
Of course, but it should be there as a last resort, and it's not with student loans. That alone is a good reason to refinance students loans to anything that's not legally a "student loan" asap. – R.. Jan 29 at 17:53
    
I can't say I agree with you there. Federal student loan protections help students adjust payments to make them manageable - helped me out when I left college and couldn't find a decent job, and meant I didn't have to declare bankruptcy. – Joe Jan 29 at 18:02

assuming that you don't lose your job, then this is probably a great idea. however, if you run into financial trouble, it will be a lot harder to manage with the extra loan payments. to make the right choice you will need to consider the odds of losing your job, the time it will take you to get a new job, and the size of your emergency fund.

another thing to consider is that student loans can usually be put into deferment fairly easily (especially federally subsidized loans). basically, you tell the bank you lost your job, and they let you skip some payments without ruining your credit. these 1-yr loans are almost certainly not going to be ok with that.

side notes:

  1. student loan interest can be tax deductable (subject to income limits), but this won't cover the 4%+ gap in interest rates of your specific case. a good rule of thumb is to multiply student loan interest rates by 0.75 when comparing to non-deductable interest rates.
  2. instead of using a 3% loan to refinance part of your student loans, you might look into refinancing and/or consolidating all of your student loans. even if you end up paying 4% interest, you save some interest on all the balance rather than just part of the balance, and the loan may still qualify as a student loan for tax purposes.
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The main drawback, is that you will be increasing the size of your commitments over the repayment schedule of the short-term loan. However you will be lowering the amount of interest you pay long-term on your student loan.

If you can afford to continue making the same payments on your student loan as you already do, and this short term loan, then I say go for it. It will save you some money.

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