Student Loan Debt: Is Consolidation The Answer?

By Katie Adams AAA

If you have more than one student loan, you may have heard about or considered consolidating your loans. Consolidating student loans is a process where you take out a new loan, which is then used to pay off your other existing student loans. If you are successful in getting the new loan, you're then responsible for repaying the one, larger loan. You can consolidate all federal student loans and most private student loans. However, before you rush to apply, it's important to know the potential benefits and downfalls of consolidating student loans. (For background reading, see Debt Consolidation Made Easy.)

In Pictures: Credit Card And Debt Management

Eligibility Requirements
In most cases you are considered eligible to consolidate your loans if you are:

  • not currently in school or are enrolled at less than part-time status
  • currently making loan payments or are within the loan's "grace period"
  • have a good repayment history (meaning you are not in default on your loans)
  • carrying at least $5,000-$7,500 in loans

You cannot consolidate private student loans with federal student loans, and you can only consolidate the loans you hold in your name; this means that you cannot consolidate your own loans with your spouse's or with loans your parents may have taken out to finance your college education. (Some savings vehicles may be better than college saving funds, check out Pay For A College Education With Retirement Funds.)

Each lender has its own minimum loan balance necessary for loan consolidation; however, you do not need to meet any minimum loan balance for loans consolidated under the Federal Direct Consolidation Loan program.

Advantages of Consolidating
There are several potential advantages to consolidating your student loans including:

1. Streamlining your bill payment process. With more than one student loan, you probably have to remember multiple due dates for your monthly repayments. With just one loan, you have only one repayment due date to remember and one check to write.

2. Extending your repayment term. If you are having difficulty repaying your loans or you anticipate a change in your income or expenses, you may want to consolidate so that you can lengthen the amount of time you have to repay your loans. However, extending the repayment term, or life of the loan, comes at a cost since you will be paying interest on the new loan for a longer period of time. (Follow these five steps to manage debt without cutting up your credit cards in Define Your Personal Debt Redline.)

3. Lowering your interest rate. If you have one or more private student loans and have improved your credit score since obtaining your loan you may be able to qualify for a consolidated loan with a lower interest rate.

4. Switching from a variable to fixed-rate loan. If you have private student loans at differing variable rates of interest, you may be able to consolidate and get one new loan with a fixed rate of interest. (Learn more in Which is better, a fixed or variable rate loan?)

5. Lowering the monthly payment amount. Lengthening the term of your loan means that you will be paying less each month.

6. Getting into an alternate repayment plan. Your life circumstances may have changed since you first took on your student loan and the repayment plan you have - for example, the typical 10-year standard repayment plan for most federal loans - may not best fit your current financial situation. Consolidation offers a way to select among other repayment plans such as the following federal consolidation loan repayment options:

  • Extended repayment stretches your loan repayment period from 10 to between 12 and 30 years (depending on your loan balance).
  • Graduated repayment allows you to begin payments at a lower monthly amount and then gradually increases that repayment amount each two years.
  • Income-contingent repayment plans determine your monthly repayment amount based on your income and total outstanding debt and then periodically change that amount as your income changes.
  • Income-sensitive repayment plans calculate your monthly payment amount as a percentage of your pretax monthly income. (Find out why good intentions can put consumers in an even bigger hole than before in Digging Out Of Personal Debt.)

7. Getting borrower benefits. Lenders will often offer loan holders certain benefits for being a good borrower. If your lender does not provide any benefits, you may want to consider consolidating your loans with a lender who does. Types of benefits can include discounts on interest rates for automatic payments made from your bank account and/or paying on time.

Potential Disadvantages of Consolidating

Depending on the type of loan that you're considering, there may be potential disadvantages to consolidating your student loans including:

  • paying more in total interest
  • having a larger total loan repayment amount
  • extending your loan period, meaning you'll be paying longer
  • losing borrower benefits from your current lender (i.e. interest rate discounts, rebates)
  • having to repay borrower benefits (i.e. rebates, fee waivers)
  • possible prepayment penalties
  • loss of grace period (if you consolidate loans during their initial grace period)

Beware of Fraudulent Lenders
Unfortunately, there are also unscrupulous lenders offering to consolidate student loans. You should be wary if a lender promises to dramatically lower your interest rate by consolidating your federal student loans. The truth is that lenders weight the average of the interest rates you're currently paying on your existing federal student loans and then round that number up to the nearest one-eighth of a percentage. While the interest rate on the new loan may be lower than the higher interest rate, it will also be higher than the lower interest rate you're currently paying. So overall you'll be paying about the same or perhaps just slightly more for your new, consolidated loan. Let's look at an example.

Example - Loan Consolidation Scam
Marisa is paying 3.6% on a $3,500 Stafford loan and 6.8% on a $6,500 Stafford loan. If she were to consolidate those loans, a legitimate lender would calculate her new interest rate using the following formula:
($3,500 x 3.6%) + ($6,500 x 6.8%) / ($3,500 + $6,500) = 5.68%
This would be rounded up to 5.75%.
While the overall interest rate on the consolidated loan is less than the 6.8% Marisa was paying on the $6,500 loan, it\'s significantly more than the 3.6% she was paying on the $3,500 loan.

You should also be skeptical if a lender charges you an upfront fee (or fees) that you need to pay out-of-pocket to consolidate your federal loans. Fees and/or expenses associated with federal loans should be deducted from the loan check, not charged to loan holders. (The devil is always in the details! Find out what you're signing yourself up for in How To Read Loan And Credit Card Agreements.)

Lastly, be cautious if a lender states that you have to choose another repayment plan for your federal loan. If you have a Perkins, Stafford or PLUS loan you can choose to stick with the 10-year repayment plan for your consolidated loan. (Some short-term loans can provide much-needed cash, but the instant payout comes at a cost. See Refund Anticipation Loans: Ripoff Or Royal Screwjob?)

Evaluate Your Options
Before you apply to consolidate your student loans, you should consider the following:

  • The interest rate you're currently paying on your loans and how it would compare to the interest you'll be charged on a new, consolidated loan
  • Whether your current loans include any prepayment penalties which, you would have to pay as you are paying those loans off early through the act of consolidation
  • Whether you stand to lose or possibly gain borrower benefits with your new lender
  • If you have the financial ability to meet the new monthly loan payment amount
  • How much longer you will need to repay the loan and how much more in total interest you will have to pay as a result. (Get off that sinking ship with a portfolio life preserver. Read Invest In Spite Of Debt and 5 Financial Mistakes New Graduates Must Avoid.)

Conclusion
There are a number of issues to consider when choosing whether to consolidate your student debt, and consolidation is not for everyone. Although consolidation can provide convenience and a number of benefits for a person with numerous student loans, consolidated loans can also charge slightly higher interest rates. You should fully investigate the consolidating loan and know what you're getting into before making this decision.

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