The Big Picture: Is Consolidation Good or Bad?
Dear Betsy,
I recently graduated and have just started paying my student loans. I have received several letters about the benefits of consolidating my student loans (I have 2 loans). The letters say that interest rates for student loans are at an all time low and that by consolidating I can lock in a low interest rate of only about 4%. Is this true, and if it is, is it a good thing to consolidate my loans? Does loan consolidating negatively affect my credit rating? Any comments would help. Thank you.
Sincerely,
Kharin
Dear Kharin,
Congratulations on your diploma AND for not automatically buying into the current consolidation “hype” without asking some questions first! Let’s talk about how consolidation works, and then we’ll get into the pros and cons.
When you have your student loans consolidated, the lender you choose will pay off your individual loans to their perspective holders and create one new loan. The terms for this new loan are generally longer; between 12 and 20 years rather than the 10-year term that’s given on your current loans. By having longer to pay the loan off, you end up with a lower monthly payment amount. The interest rate on a consolidation loan is determined by taking the weighted average of your current loans’ interest rates and rounding up to the nearest percent (this means that the interest rate on a $10,000 loan “counts” more towards the bottom line than a $5,000 loan’s interest rate). This interest rate is “fixed”, which means it will not change throughout the life of the loan whereas your current loans are “variable” which means they either increase or decrease on an annual basis.
Here’s an example of how a consolidation could turn out. Let’s say your 2 loans consist of a $10,000 unsubsidized Stafford at 4.06% and a $5,000 Perkins loan at 5% and both loans have 10-year terms. You are paying $105 per month on the Stafford and $50 per month on the Perkins for a total of $155 per month for 120 months (10 years). If you were to consolidate, you would end up with a $15,000 loan at a fixed 4.375% interest rate for 15 years at approximately $114 per month.
Pros: With the exception of consolidation loans, Perkins loans and a few others, most federal student loans have variable interest rates that are capped at 8.25%. This means that depending on how the economy is doing, your interest rate can change every year and could go as high as the 8.25%. Right now we’re seeing the lowest interest rates in federal student loan history with most borrower’s set at around 4.06% or 4.79% depending on when they took their loans out.
By consolidating, you are ensuring that for however long it takes you to pay it off, the rate will never change from what you get in the consolidation. This means that assuming student loan interest rates go up over the next few years you will be saving money in interest. The other benefit of consolidation is that you will only need to send 1 payment to 1 company per month rather than dealing with the multiple lenders you may currently be dealing with.
Cons: If the interest rates should happen to go down again, your stuck with the rate you have which means you may end up paying more over the life of the loan. Also, by extending the terms, you are again increasing the total amount you pay back. You only get charged interest on whatever your outstanding balance is so the longer you take to pay, the more you pay. This principle is the same for almost every type of consumer loan including credit cards, car loans, etc. For example, in the examples listed above, if you didn’t consolidate and the interest rates didn’t go up, you would end up paying back a total of approximately $18,600 whereas if you did consolidate you would pay back approximately $20,520. At this point you’ve counteracted the lower interest rate by taking 5 extra years to pay off the loan! On the other hand, if you didn’t consolidate and rates went up to their maximum of 8.25% for a good period of your repayment, you could end up paying as much as $21,054 over the life of the loan. There’s also a chance you may lose some benefits or loan forgiveness options that are available to you on your current loans, but for which consolidation loans are not eligible.
Bottom line is that consolidating can be a gamble. I would 1st check on any loan cancellation, forgiveness or other options you may lose out on by consolidating by talking to your loan holders. If not, I would consider looking into consolidation, but continue to make the same monthly payment amount as you do now. This way, you can lock in the lower interest rate but not run the risk of counter-acting it by taking longer to pay. Hope you and other readers find this helpful.
I’m usually not so long winded but this is one of my FAVORITE subjects!
Betsy
