December 5, 2011

Should You Consolidate Your Student Loans?

Federal loan Consolidation

When you consolidate federal loans they give you a weighted average interest rate.    The interest rate doesn't change over all.   OK, actually they may round to the nearest 1/8 % but the rate won't change too much.    Its not like you can take your old loans at 6.8% and get a "great rate" like when you refinance a house.  

How does the weighted Average interest work?

Weighted average means you figure the average amount of something differently due to individual items having different weights.   For the student loans a loan with a higher balance would have more weighting than a loan with a small balance.   The general formula would be like this :

(Loan #1 balance * Loan #1 % rate) + (Loan #2 balance * Loan #2 %) ... + (Loan #n balance * loan n %)
-- divided by --
(Loan #1 balance + Loan #2 balance ... + Loan #n balance)

So for example lets say you have 3 loans :   Loan #1 is $5000 at 5%, Loan #2 is $1000 at 10% and Loan #3 is 6% at $3000.   You do NOT just average 5%, 10% and 6% and get 7%.    That 10% loan is only $1000 balance so it has much lower weighting than the other two loans.  The weighted average formula would work like this :
($5000 * 5% ) + ($1000 * 10%) + ($3000* 6%) / ($5000 + $1000 + $3000) =
250 + 100 + 180 / 9000 =
530 / 9000 =
.0588
=5.88%

The low interest 5% loan has a higher balance than the other two loans so it weights the average more.  Thats why your weighted average is closer to 5% than 6% or 10%.

You might look at this and think you must be getting a better deal.   I mean isn't a single 5.88% loan better than a 5%, 6% and 10% loan?     No, because the 5.88% is paid on a much larger balance than the 6% and 10% loans were.

You can verify that by figuring the straight interest rate you'd pay in a year for the 3 loans as a sum versus the 5.88% loan on $9000.

Individually you'd pay interest of :
5% of $5000 = $250
6% of $3000 = $180
10% of $1000 = $100
totaling = $530

After consolidation you'd pay :
5.88% of $9000 = $530

See?  Its the exact same interest in the end.   No wait I lied.   Remember that the interest rate may get rounded to the nearest 1/8 %.    Well 5.888% is going to round up to 6% so the actual rate with consolidation may get rounded up to 6% in this case.   That would give you a interest of 6% of $9000 or $540.  

Private Loan Consolidation

Consolidation of private loans is more like refinancing a debt.   You have to go to the lenders and see what kind of rate they will give you.    Consolidating can have the benefit of giving you one large loan that can be paid over longer period.   Your interest rate may even go down if your credit score is a lot more appealing now than it was in the past.   Private loan rates generally vary based on market interest rates.   You may pay something in the range of prime rate + 1% to prime rate + 6%. 


Who Can Consolidate?

If your loans are in payment and not in default then you can usually consolidate them.    Married couples can no longer combine their loans while consolidating.  Parents who have parental student loans can also get consolidation.

Benefits to Consolidate


There are several potential benefits to consolidation :

1) Longer repayment plans.    This I think is the biggest benefit of consolidation.   With consolidating you can pick alternate repayment plans with terms up to 30 years.    Normally the default repayment plan for a student loan is 10 years.   If you consolidate and go with a longer repayment plan this will give you a lower monthly payment.   This can be a good idea if you have a lot of loans and really struggle to make your payments.
2) Some lenders give bonus discounts on the loan.  0.25% interest rate deduction for using automatic payment is a common incentive.    You may also qualify for a 1% rate reduction if you make on time payments for 3 years straight.
3) Easier to deal with single loan.   Over several years in college you may have several loans with different lenders.   Consolidating will give you a single loan with a single payment.  Its just a little easier to deal with.

The #1 item is the major reason to consolidate.   #2 and #3 are minor details in comparison.

Should you consolidate?

Ok so should you?     Since you can't combine federal and private loans it boils down to two separate situations.  If you have federal loans you can consolidate them as a group or you can also consolidate private loans separately as a group.    In either case you may want to consolidate in order to extend the repayment period and get a lower monthly payment.    This is an OK option if you have large loans and its hard for you to make the payments with the normal 10 year term. For private loans the question also depends on if you can get an interest rate deduction.  If you can drop the rate considerably then consolidating a private loan can be well worth your while.

Why you shouldn't consolidate = More Interest

If you can make your payments without much difficulty then there generally isn't a good reason to consolidate federal loans.   Extending your repayment period will increase the total interest you pay.   You're better off just paying them with the normal 10 year term.   Same goes for private loans however if you can get a lower interest rate with a private loan then that could make consolidation worth while in any case.

Income Based Repayment Could be a Better option

The major reason to consolidate is to extend the repayment term with the objective of getting lower payments.   If you have large loans and difficulty paying them then you may be eligible for Income Based Repayment IBR for the federal loans.  

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