Why Consolidate Student Loans?

By Mark Kantrowitz

Student loan borrowers should consider consolidation carefully. There are several arguments in favor of student loan consolidation and several arguments against consolidation.

Also, once a borrower's student loans have been consolidated, the consolidation cannot be undone. The new consolidation loan pays off the original student loans, which then no longer exist.

If a borrower is consolidating federal student loans into a private consolidation loan, the borrower needs to consider any tradeoffs between a lower interest rate and fees on the private consolidation loan and the loss of the better benefits provided by federal student loans.

Benefits of Consolidation

There are several reasons why a borrower should consider consolidating his or her student loans.

• One bill. Consolidation streamlines repayment by replacing multiple loans with a single loan. The typical college student graduates with as many as a dozen student loans, or more. Refinancing them into a single loan makes repaying the student loans easier to manage.
• Restarts the repayment term. The consolidation loan starts with the full repayment term. This may reduce the monthly payment even if the borrower sticks with a standard 10-year repayment term. For example, suppose a borrower begins repayment with $25,000 in student loans at 6.8% interest and a 10-year term, with a monthly loan payment of $287.70. If the borrower decides to consolidate the loans at the same interest rate three years into the 10-year repayment term, the new loan balance will be $19,186.36. Since the consolidation loan is a new loan with a new 10-year repayment term instead of continuing where the original loan left off, the monthly payment decreases to $220.80. This reduces the monthly payment by $66.90, but increases the total payments over the life of the loan by $2,329.20.
• Resets the clock on deferments and forbearances. Federal student loans have a 3-year limit on deferments and forbearances. Private student loans have a 1-year limit on forbearances. Borrowers can obtain a fresh set of deferments and forbearances by consolidating their loans. The consolidation loan is a new loan with a new set of deferments and forbearances.
• Eliminates overlap among multiple minimum payments. When a borrower has several small loans, minimum payment requirements may increase the amount the borrower must pay each month. By consolidating these loans, the borrower replaces multiple minimum payments with just one. For example, the Federal Stafford loan has a $50 minimum monthly payment. Suppose a borrower has two Federal Stafford loans with a 6.8% interest rate, one with a $3,500 loan balance and one with a $4,500 loan balance. The $3,500 loan would normally have a $40.28 monthly payment, but this gets increased to $50 because of the minimum monthly payment. The monthly payment on the $4,500 loan is $51.79, above the minimum payment. The combined monthly payment is $101.79. If the borrower were to consolidate the two loans, the new monthly payment would be $92.06, above the minimum monthly payment. This reduces the total monthly payments by $9.73, but increases the total payments over the life of the loan by $362.22.
• Lower interest rate. The interest rate on a federal consolidation loan is based on the weighted average of the interest rates on the loans included in the consolidation loan, rounded up to the nearest 1/8th of a percentage point. The new interest rate is usually between the highest and lowest interest rates. The use of the weighted average preserves the cost of the loan. The interest rate on a private student loan is based on the credit scores of the borrower and the cosigner (if any). If the credit scores have improved, this may yield a lower interest rate.
• Switches to a fixed or variable rate. If a borrower currently has fixed interest rates and prefers variable interest rates, refinancing the loans into a private consolidation loan may be one approach to obtaining a variable interest rate. Likewise, a private consolidation loan may allow a borrower to switch from variable interest rates to a fixed interest rate.
• Reduces monthly loan payments. Switching to a longer repayment term will generally reduce the monthly loan payment, but at a cost of increasing the total interest paid over the life of the loans.
• Cosigner release. Some private student loans do not provide cosigner release options. Others do provide cosigner release, but the borrower might not qualify. By refinancing the student loans into a new private consolidation loan without a cosigner, however, the borrower can obtain the equivalent of a cosigner release.
• Access to alternate repayment plans. Without consolidating, federal student loans offer an extended repayment term of 25 years for borrowers with more than $30,000 in student loan debt. But, the borrower can get a 30-year repayment term by consolidating his or her student loans.
• Switches lenders. If a borrower doesn't like his or her lender, the borrower can switch lenders by consolidating his or her student loans with a different lender.

Disadvantages of Consolidation

There are several reasons why a borrower should not consolidate his or her student loans.

• May increase cost of the loan. Increasing the repayment term increases the total interest paid over the life of the loan. When thinking about consolidating student loans, compare the total payments over the life of the loan in addition to the change in the monthly loan payment.
• May lose subsidized interest benefits. The federal government pays the interest on Federal Perkins loans and subsidized Federal Stafford loans while the borrower is in an authorized deferment. If the borrower consolidates the Federal Perkins loan into a federal consolidation loan or either loan into a private consolidation loan, the new loan loses the subsidized interest benefits.
• May lose remainder of grace period. When a borrower consolidates a student loan, the borrower loses the remainder of the 6-month grace period.
• May lose loan forgiveness options. Private consolidation loans do not offer public service loan forgiveness. By consolidating federal student loans into a private consolidation loan, the borrower will lose the opportunity to apply for public service loan forgiveness, teacher loan forgiveness and other loan forgiveness programs. Borrowers who consolidate Federal Perkins loans into a federal consolidation loan lose the loan forgiveness options provided by the Federal Perkins loan.
• May lose loan discharge options. Federal student loans provide death and disability discharges. Borrowers who consolidate federal student loans into a private consolidation loan may lose these benefits as most private consolidation loans do not offer death and disability discharges.
• Capitalization of interest. Interest is capitalized (added to the loan balance) when a loan is consolidated or undergoes status changes. Thus, consolidating a student loan may cause interest to be charged on interest.
• Can't target highest-rate loan for quicker repayment. If a borrower's loans have been consolidated, the borrower will not be able to target the loan with the highest interest rate for quicker repayment. Consolidation replaces the various loans with a single loan with a single interest rate. Generally, if the interest rate on the consolidation loan is much higher than the weighted average of the interest rates on all the loans but the highest-rate loan, the borrower can save more money by making extra payments on the loan with the highest interest rate. This assumes that the borrower will be able to pay off the highest-rate loan quickly.
• Interest rates may not be lower. The interest rates on a private student loan are based on the current credit scores of the borrower and cosigner (if any). If the credit scores have not improved since the loans were borrowed, the borrower might not qualify for a lower interest rate. Generally, it takes several years after graduation for the borrower's credit scores to improve significantly if the borrower manages his or her credit responsibly, making on-time payments on all debts (not just student loans). Also, if the borrower is refinancing a cosigned loan without a cosigner, the borrower's credit scores must be better than the cosigner's original credit scores, not just the borrower's previous credit scores.
• May lose repayment plans. Most private consolidation loans do not offer income-driven repayment plans. Borrowers who consolidate federal student loans into a private consolidation loan may lose access to the flexible repayment plans that are available for federal student loans.
• May lose longer deferments and forbearances. Deferments and forbearances on federal student loans are three years in total duration, compared with one year for private student loans. By consolidating federal student loans into a private consolidation loan, the borrower may lose access to the longer deferment and forbearance periods.
• May lose borrower benefits. Borrowers who consolidate their student loans may lose borrower benefits that were associated with the original loans, such as interest rate reductions, principal rebates and other student loan discounts.