Farrell: Though tempting, it's best to keep student loans

Q I have a Stafford student loan, $45,000 with a fixed annual percentage rate of 4.5 percent. Currently this loan is with ACS Education. However, this loan has been sold more than 10 times in the last eight years and I feel that it's a matter of time before it is sold again to another firm.

I bank with AffinityPlus and have accrued many points to buy down the interest rate. Does it make any sense to get a personal loan with a low interest rate (3.5 percent or lower) and pay off this student loan, then pay off the balance with my bank in a payment plan of $700 a month for the next five years?

I'd love your opinion.

TA 

A To cut to the chase, I'm not a fan of this financial maneuver.

I've gotten a number of questions similar to yours. The desire to take advantage of lower rates is understandable. A number of people have told me about problems associated with a new student-loan servicer.

Still, the trade-off to weigh is the flexibility of student loans in case you run into trouble versus interest rate savings.

Since I usually worry about the unexpected downside -- what could go wrong? -- I think you would be giving up too much flexibility for too small a gain. To my thinking, the debt repayment flexibility built into the terms of federal student loans is a critical consideration and, by that metric, I would keep the federal student loans.

Here's my reasoning: I don't need to tell you that we live in a tough economy. Let's say that sometime over the next several years you lose your job, are forced into part-time work, get seriously ill, or simply face a period of time when money is tight. You have a number of repayment options with your federal student loans. You can put them into forbearance or deferment. You can change the terms of the loans and lower the monthly tab.

Yes, by taking advantage of any of these options you'll increase the overall cost of the loan. However, since there's no prepayment penalty with federal student loans, you can always accelerate payments later on when your financial circumstances are better.

In that case, you would have bought yourself some financial breathing room upfront without hiking the overall cost of your education (or, at least, by not much). Depending on your income, interest on student loans may be deductible up to $2,500 through this year. The deduction may change after 2012, however.

Compare that with a personal loan. Yes, the rate is lower. Yet the personal-loan lender doesn't care if you fall into financial trouble. The lender wants you to make the loan payments on time and at the stated amount. In essence, the terms are inflexible. There's no built-in safety valve. You can't deduct interest payments if you itemize when filing your federal tax return.

You have a much greater margin of safety with the federal student loans compared to the bank loan. If you can, I think it would be much better strategy to get more aggressive about paying off the student loans, putting any extra payments toward reducing principal.

Meanwhile, let's hope Congress gets its act together and prevents the federally subsidized student loan rate -- currently at 3.4 percent -- from jumping to 6.8 percent in July. We'll see.

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org.

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