Consolidating Student Loans Is Not a No-Brainer

Question: I recently graduated from college and currently have three different student loans outstanding. I know consolidating my student loans is an option, but is it a good idea?

Answer: With graduation season just ending, many newly minted grads surely must be wondering the same thing. About two-thirds of college seniors graduated with loans in 2010, owing an estimated $25,250 on average, according to a report by The Project on Student Debt.

This debt might consist of a grab bag of federal and/or private loans taken out by students or their parents. To streamline the payment process, many borrowers choose to consolidate these loans. However, don't expect loan consolidation to save you money. In fact, it might cost you slightly more in interest because of how consolidated loan rates are calculated.

New Rate a Weighted Average, Rounded Up
Consolidated loan rates are weighted based on the rate and amount owed for each individual loan to be included. For example, if a borrower owes $10,000 at 4% interest and $5,000 at 7%, the consolidated rate on the new $15,000 loan would be 5%. This new consolidated loan rate also is rounded up to the nearest one eighth of a percentage point. So a weighted average of 6.2% would be rounded up to 6.25%, which equates to less than $0.40 extra per month, and just $45 in added interest payments, on a $15,000 loan over 10 years.

Consolidation Rules
Federal student loans may be consolidated through the Direct Consolidation Loan program. It allows for the consolidation of most federal loans, with no minimum or maximum loan amounts required. There is no fee to consolidate, nor is there a prepayment penalty. Borrowers who are in default may still be able to consolidate their student loans as long as they agree to a repayment plan. Even a single loan may be consolidated, for example, as a way to extend the repayment period; however, a consolidated loan may not be consolidated a second time unless new loans are added to it. (A Special Direct Consolidation Loans program aimed at borrowers with federal loans held by the Department of Education and private lenders runs through the end of June. Details can be found here.) Multiple borrowers may not consolidate loans into a single new loan. So parents may not consolidate loans taken out in their names with those taken out in their child's name. Likewise, spouses who both have student loans may not consolidate them into a single loan.

Private loans may be consolidated through the private lender but cannot be included in a federal loan consolidation. Also, while federal consolidation loans have fixed rates, private consolidation loans typically have variable rates, which could push interest costs up if rates climb.

When Consolidation Makes Sense
The most obvious benefit to consolidating student loans is convenience. Instead of writing several checks each month, the borrower writes just one (or better yet has the payment auto-debited from his or her bank account, which typically shaves one-quarter of a percentage point off the loan).

Another potential benefit for borrowers struggling to make monthly payments on their loans is that consolidation allows them to extend the repayment period of the loan to as much as 30 years. This results in lower monthly payments but higher overall interest costs over the life of the loan compared with the standard 10-year repayment period. The financial aid website FinAid.org offers a loan consolidation calculator to help borrowers estimate how much they would pay under various scenarios.

Before 2006, federal loans had variable rates, making consolidation an attractive option for those looking to lock in fixed rates. But now that federal loans are fixed this is no longer a benefit. Also, federal consolidation loan rates are capped at 8.25%, meaning that parents with PLUS loans at 8.5% could save money by consolidating. However, PLUS loans have been fixed at 7.9% since 2010, according to FinAid.org, so this benefit may not apply in many cases.

When Consolidation Isn't the Best Choice
Under some circumstances, consolidation might not be a good idea. For example, if a loan includes special discounts--such as a rate reduction for making payments on time--those might not be factored into the consolidated rate, meaning that the borrower might be better off leaving the loan alone, so to speak.

Consolidation also might not make sense if the borrower has loans with widely varied interest rates, says Mark Kantrowitz, publisher of FinAid.org. In that case he or she might want to preserve the option of making extra principal payments on the higher-interest loan to pay it down more quickly and save on borrowing costs. If the loan is consolidated, however, this is no longer an option because it becomes part of the new consolidated loan rate. "Let's say that you have a subsidized Stafford loan at 3.4% and another Stafford loan at 6.8%. If you accelerate payments of the higher rate you pay it off faster," Kantrowitz says. "By consolidating, you can't pay it off faster."

Consolidation also is not likely to be a good idea for new grads who aren't yet earning a paycheck. For new grads, the first student loan payments might not be due for several months, but once loans are consolidated, the first payment typically is due within 60 days. Still, says Kantrowitz, for grads who plan to consolidate their loans and who have jobs--by no means a given these days--there's no time like the present to set up a consolidated-loan automatic-payment plan. Doing so eliminates the risk of missed payments, cuts down the interest rate, and gets them a few months closer to paying off their loans.

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