Why Consolidate?
This page discusses the pros and cons of consolidation. Although theswitch to fixed interest rates on Stafford and PLUS loans eliminatedone of the financial incentives to consolidate, there are stillseveral reasons why borrowers may want to consolidate their educationloans.
Reasons to Consolidate
The key benefits of a consolidation loan include the following:
- Single monthly payment.Consolidation replaces the multiple payments on multiple loans with asingle payment on the consolidation loan. A student might graduatewith as many as a dozen loans or more. Consolidation combines theseinto a single loan with a single monthly payment. This simplifies therepayment process.
- Alternate repayment plans. (More manageable monthly payments.)Consolidation provides access to alternate repayment plans, such asextended repayment, graduated repayment, and income contingentrepayment. Although these plans may be available to unconsolidatedloans, the term of an extended repayment plan depends on the balanceof the loan, which is higher on a consolidation loan.
Alternate repayment plans often reduce the size of the monthly paymentby as much as 50% by increasing the term of the loan. This can makethe monthly payments more affordable and management, but it doesincrease the total interest paid over the lifetime of the loan.
- Reduces the interest rate on some PLUS loans.Consolidating an 8.5% fixed rate PLUS loan reduces the interest rateby 0.25% because of the lower 8.25%interest rate cap on consolidation loans. To maximize the interestrate reduction, the PLUS loans must be consolidated bythemselves. However, one must also consider the impact ofconsolidation on available student loan discounts.
- Resets the clock on deferments and forbearances.Consolidation resets the 3-year clock on certain deferments andforbearances. A consolidation loan is a new loan, with its own freshset of deferments and forbearances.
This is a useful tool for medicalschool students, who do not get an in-school deferment during theinternship and residency periods. They are, however, eligible for aneconomic hardship deferment for up to three years. If they need morethan three years, consolidation is a useful tool for getting up to anotherthree years of deferment.
- Restarts the loan term on loans already in repayment.Even if you stick with standard ten-year repayment, when youconsolidate loans that are already in repayment, it resets the loanterm on those loans, since a consolidation loan is a new loan. Thiscan give you some of the benefits of an alternate repayment plan, suchas a lower monthly payment, without extending the term as much astypically occurs with extended repayment.
On the other hand, if you are close to the end of your repayment term,you might want to avoid consolidation because the savings will not begreat enough for it to be worth the bother.
- Switch lenders for better loan discounts.Consolidating your loans allows you to switch from one lender toanother. You can also switch from Direct Loans to FFEL and viceversa. If you shop around, you might be able to get a better discounton loan interest rates and better rebates on the fees.
With the switch to fixed rates on Stafford and PLUS loans firstdisbursed on or after July 1, 2006, the ability to lock in theinterest rate on a variable rate loan is no longer relevant for mostborrowers. Students could also previously consolidate during the in-school orgrace period to lock in the lower in-school interest rate usingthe in-school interest rate loophole, whichwas repealed in 2006.
Nevertheless, borrowers who still have unconsolidated variable rateloans may wish to consider consolidating during the grace period tolock in the lower in-school rate. (The interest rates on variable rateloans also change each July 1, based on the last 91-day T-bill auctionin May. Depending on whether the rates are increasing or decreasing,borrowers might want to consolidate before or after July 1. Manylenders will hold the consolidation loan application to provideborrowers with the best rate and to maximize the grace period. Butwhen interest rates are less volatile, consolidating during the graceperiod is often more important than the July 1 change in rates.)
Some graduate students have found it necessary to consolidate theireducational loans when applying for a mortgage on a house.
Caveats
There are, however, a few problems with consolidation that you shouldbe aware of when considering a consolidation loan:
- Loss of the Grace Period.When a borrower consolidates during the grace period, the borrowerhas to begin repayment immediately and loses the remainder of thegrace period, including possibly interest benefits on subsidized loans.
However, several lenders will delay the payoff of your original loansfor as long as possible, to allow you to derive maximum benefit fromthe grace period on those loans. This involves exploiting the grace period loophole. Alternately, if you cannot begin repaying the consolidation loanbecause you are still looking for a job, you can apply for anunemployment deferment or an economic hardship deferment. Thesedeferments allow you to delay repaying the loans for up to threeyears. Interest continues to accrue on unsubsidized loans, and musteither be paid or added to principal through capitalization. (Notethat you must continue making payments on the consolidation loan untilyour application for a deferment is approved. If you fail to makepayments, your loan will go into default, and this will prevent youfrom obtaining a deferment.)
- Loss of subsidized interest benefits on Perkins Loans.The interest benefits on a Subsidized Stafford Loan surviveconsolidation. This means that the federal government continues to paythe interest on the portion of the consolidation loan that resultedfrom the payoff of a subsidized Stafford loan while the borrower is inschool or during other deferment periods. The interest benefits on aPerkins Loan, however, do not survive consolidation.
- Loss of other benefits of the Perkins Loans.In addition to losing the Perkins loan's 9-month grace period andsubsidized interest, borrowers who consolidate Perkins Loans also losethe Perkins Loan's favorable loan forgiveness provisions.
- Extended Repayment is Optional, Not Mandatory.Extending the repayment term may increase the total interest paidover the lifetime of the loan.
Some lenders have been encouraging (or at least, not discouraging)borrowers to obtain extended repayment on their consolidationloans. They do this in subtle ways, such as using a 20 year terminstead of a 10 year term in their repayment examples.
Borrowers are not required to pick an alternate repayment term, likeextended repayment. Borrowers can stay with standard ten-yearrepayment even if they consolidate. We recommend keeping a standardrepayment term, as this minimizes the total cost of the loan.You should only choose an extended or alternate repayment term whenyou are experiencing trouble making your monthly payments. Thealternate repayment terms can reduce the size of the monthly paymentsby as much as 50%, but at a cost of increasing the total interest paidover the lifetime of the loan by as much as 250% or more. Thealternate repayment plans can increase the cost of the loan bythousands or even tens of thousands of dollars.
Lenders have a financial interest in encouraging borrowers to usealternate repayment. Lender profits are increased when borrowers havehigher loan balances for longer terms. A 20 year term, for example,increases the average annual loan balance by about 10% as comparedwith a 10 year term, and doubles the repayment term. So the totalinterest paid is about 2.2 times higher on a 20 year term as comparedwith a 10 year term. Lender margins are tighter on consolidationloans, due to fees paid to the US Department of Education, so theirannual profit on a consolidation loan is lower. However, if they canconvince the borrower to use extended repayment, the total profitsover the lifetime of the loan are higher.
Some of the arguments lenders give in favor of extended repayment arereasonable. For example, if you have several forms of debt, you shoulduse extra funds to pay off the more expensive (higher interest rate)debt first. This can save you money. You could extend the repaymentterm on your low cost federal student loans to reduce the size of themonthly payment, and use the savings to pay off your private studentloans and credit card debt sooner. This can be part of a good debtmanagement strategy that minimizes the total cost of all yourdebt. But it requires discipline, and extending the term on youreducation loans will increase their cost, especially if you fail topay off your higher interest debt. So don't do this if you're justgoing to spend the savings.
Another argument involves comparing the costs of interest on yourstudent loans with stock market returns. If you have some extra moneyavailable, should you prepay part of your student loans, or invest themoney in the stock market? Although the stock market has the potentialfor greater returns, it is also much riskier. Unless you have a lot ofexperience with investing, you are probably better off trying to payoff your debt as quickly as possible.
After all, do you really want to still be paying off your own studentloans when your children are ready to enroll in college?
- You can only consolidate once.Current law allows borrowers to consolidate their loans only once. Ifyou want to include a previous consolidation loan in a newconsolidation loan, you must be adding other loans to theconsolidation loan. Thus, your ability to use consolidation to switchfrom one lender to another will be severely limited after youconsolidate, unless you held one or more loans out of theconsolidation.
Note that even if you are able to consolidate a previous consolidationloan, reconsolidation does not relock the interest rates onthe existing consolidation loans. Once the interestrate on a consolidation loan is fixed, it does not change.
- Inferior loan discounts.Lenders who offer borrower benefits for electronic fundstransfer and making payments on time tend to offer less favorablebenefits for consolidation loans. Most lenders offer a 0.25% interestrate reduction when you sign up to have your monthly payments directdebited from your bank account. However, the typical discount formaking all of your payments on time is a 1% interest rate reductionafter 36 months of on-time payments, instead of 2%. This is partlybecause the profit margins on consolidation loans are tighter than onunconsolidated loans. However, we expect to see increased competitionon price among consolidators, now that the single holder rule has beenrepealed, so consolidators may soon start offering better discounts toencourage borrowers to switch lenders. Originating lenders andsecondary markets may respond by improving the benefits for loans thatremain unconsolidated.
- Capitalization at Status Changes. Accrued interest on anunsubsidized Stafford Loan must be capitalized when the loan is consolidated.
- You don't need to consolidate to get extended repayment.A little known provision of the Higher Education Act of 1965, insection 428(b)(9)(A)(iv), allows borrowers to get extended or graduatedrepayment without consolidating their loans. The borrower must haveaccumulated more than $30,000 in federal education debt since 1998.The extended or graduated repayment plan may have a loan term of up to25 years. Per the regulations at 34 CFR 682.209(a)(6)(ix), the borrower must nothave had any outstanding federal education debt prior to October 7,1998 at the time of obtaining a new education loan subsequent to that date.Many lenders also offer unified billing, so that you get one billfor all your loans from that lender.
Before July 1, 2006, married couples could jointly consolidate theirloans. Although thiscould qualify the couple for a longer repayment term and lower monthlypayments, it often caused problems when a couple got divorcedlater. By jointly consolidating the student loans, each spouse assumesfull responsibility for repaying the debt. It is not possible to splitup the debt during a divorce proceedings, so each spouse remainsresponsible for paying back the loans. If one ex-spouse fails to makea monthly payment, the other ex-spouse is responsible, and his/hercredit record is affected. Similarly, the loan is no longer eligiblefor an in-school deferment, since both spouses must be enrolled incollege for the loan to qualify for a deferment. (If one spousedies or becomes permanently disabled, however, that portion of thedebt is forgiven.) For these reasons, Congress repealed the abilityfor married borrowers to consolidate their loans together as part ofthe Higher Education Reconciliation Act of 2005.
Consolidating a fixed rate loan, such as a Perkins Loan, will not saveyou any money on the fixed rate loan. Consolidating does not reducethe underlying rate of a fixed rate loan, although it can increase it slightly, due to therounding up to the nearest 1/8th of a point. (On the other hand, ifthe weighted average of the interest rates on the other loans wouldhave resulted in the interest rate being rounded up nearly 1/8th of apoint, including a fixed rate loan might mask some of the roundup,indirectly saving a little money. Likewise, if the weighted averagewas just below the 1/8th of a point boundary, including a fixedrate loan that bumps it over the 1/8th of a point boundary couldincrease the interest rate by up to 1/8th of a point beyond what itwould have been otherwise. Thus including a Perkins Loan in aconsolidation loan can cause the interest rate to be up to 1/8th of apercent higher or lower than it would otherwise have been, dependingon whether it moves the weighted average of the interest rates closerto or beyond the next 1/8th of a percent boundary.) However, manybanks provide a 0.25% reduction in the interest rate for signing upfor automatic bank debit, which may make consolidating a Perkins loanfinancially worthwhile. (Note that there is a financial benefit toconsolidating an 8.5% fixed rate PLUS loan, due to the lower 8.25%interest rate cap on consolidation loans.)
This page discusses the pros and cons of consolidation. Although the switch to fixed interest rates on Stafford and PLUS loans eliminated one of the financial
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