Rising Rates Pose a Risk for Students Looking to Refinance Debt

Mortgage refinancing isn't the only lending business that could face pressure from rising short-term rates.

Interest-rate savings on student-loan refinancing are also shrinking as short-term rates have started to move higher, according to a new report.

Refinancing student loans has taken off in the last five years as fintech lenders, led by Social Finance Inc. or SoFi, have been offering to replace borrowers' federal student loans with new loans that have lower interest rates.

Until recent years, rates on many federal student loans weren't based on market rates, but a higher uniform rate set by the government.

Now, the savings are declining for some of the most creditworthy borrowers. Those with the highest credit scores who refinanced early this year received an interest rate that on average was about 2.2 percentage points lower than the rate on their original loan, according to LendKey Technologies Inc., which tracks student loans at credit unions and community banks. In 2014 and 2015, the average interest rate savings exceeded 3 percentage points.

Rates on private student loans are usually pegged to the one-month or three-month London interbank offered rate, which have been moving up in recent months with the Federal Reserve's short-term interest-rate target.

Meanwhile, interest rates on newly issued federal student loans are down. Unsubsidized Stafford loans, for example, given to undergraduate students for the current academic year have a fixed rate of 3.76%, compared with 4.66% two years before and 6.8% four years prior.

The decline in federal student-loan pricing is largely the result of a repricing strategy implemented by the federal government starting for the 2013-14 academic year. Since then, federal student-loan rates have been based on a rate from the last 10-year Treasury auction that occurs each May. Between 2006 and until this change, federal student-loan rates had been set in advance by federal law.

Still, refinancing can result in significant savings for many borrowers. That includes those who still have older federal student loans at high rates. Borrowers who signed up for private student loans to attend college that have high rates could also benefit if their credit scores have since improved.

LendKey says student-loan refinances topped $200 million in 2016 for the institutions on its platform, up 80% from a year prior. It says the savings borrowers receive remain substantial, adding that the decline in savings is likely due to the small number of borrowers in some of its credit-score brackets. Borrowers who refinance their loans with credit unions and other small banks receive an interest rate that on average is 2.2 percentage points lower than the rate they were previously paying, according to the firm.

But the dip in savings among certain credit scores points to a broader issue for the student-loan refinance industry. Sustaining growth for these lenders has been largely based on how long they can offer rate savings that are large enough to give consumers the incentive to refinance. Those savings, for many borrowers, also need to be big enough to offset the fact that they are giving up federal repayment protections, such as loan forgiveness, when they switch from federal to private loans.

SoFi's chief executive, Mike Cagney, has been vocal about the limited time-span on this market for several years, warning that lenders who enter the market just to focus on student-loan refinances aren't pursuing a good strategy. SoFi has in recent years expanded to other loans, including mortgages and personal loans, pitching those products to its student-loan borrowers.

Write to AnnaMaria Andriotis at annamaria.andriotis@wsj.com

(END) Dow Jones Newswires

April 25, 2017 06:44 ET (10:44 GMT)