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Why Consolidate?

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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 incentives to consolidate, there are still several reasons why borrowers may want to consolidate their education loans.

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 a single payment on the consolidation loan. A student might graduate with as many as a dozen loans or more. Consolidation combines these into a single loan with a single monthly payment. This simplifies the repayment process.
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  • Alternate repayment plans. (More manageable monthly payments.) Consolidation provides access to alternate repayment plans, such as extended repayment, graduated repayment, and income contingent repayment. Although these plans may be available to unconsolidated loans, the term of an extended repayment plan depends on the balance of the loan, which is higher on a consolidation loan.

    Alternate repayment plans often reduce the size of the monthly payment by as much as 50% by increasing the term of the loan. This can make the monthly payments more affordable and management, but it does increase 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 rate by 0.25% because of the lower 8.25% interest rate cap on consolidation loans. To maximize the interest rate reduction, the PLUS loans must be consolidated by themselves. However, one must also consider the impact of consolidation on available student loan discounts.

  • Resets the clock on deferments and forbearances. Consolidation resets the 3-year clock on certain deferments and forbearances. A consolidation loan is a new loan, with its own fresh set of deferments and forbearances.

    This is a useful tool for medical school students, who do not get an in-school deferment during the internship and residency periods. They are, however, eligible for an economic hardship deferment for up to three years. If they need more than three years, consolidation is a useful tool for getting up to another three years of deferment.

  • Restarts the loan term on loans already in repayment. Even if you stick with standard ten-year repayment, when you consolidate loans that are already in repayment, it resets the loan term on those loans, since a consolidation loan is a new loan. This can give you some of the benefits of an alternate repayment plan, such as a lower monthly payment, without extending the term as much as typically 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 be great enough for it to be worth the bother.

  • Switch lenders for better loan discounts. Consolidating your loans allows you to switch from one lender to another. You can also switch from Direct Loans to FFEL and vice versa. If you shop around, you might be able to get a better discount on loan interest rates and better rebates on the fees.

With the switch to fixed rates on Stafford and PLUS loans first disbursed on or after July 1, 2006, the ability to lock in the interest rate on a variable rate loan is no longer relevant for most borrowers. Students could also previously consolidate during the in-school or grace period to lock in the lower in-school interest rate using the in-school interest rate loophole, which was repealed in 2006.

Nevertheless, borrowers who still have unconsolidated variable rate loans may wish to consider consolidating during the grace period to lock in the lower in-school rate. (The interest rates on variable rate loans also change each July 1, based on the last 91-day T-bill auction in May. Depending on whether the rates are increasing or decreasing, borrowers might want to consolidate before or after July 1. Many lenders will hold the consolidation loan application to provide borrowers with the best rate and to maximize the grace period. But when interest rates are less volatile, consolidating during the grace period is often more important than the July 1 change in rates.)

Some graduate students have found it necessary to consolidate their educational loans when applying for a mortgage on a house.

Caveats

There are, however, a few problems with consolidation that you should be aware of when considering a consolidation loan:

  • Loss of the Grace Period. When a borrower consolidates during the grace period, the borrower has to begin repayment immediately and loses the remainder of the grace period, including possibly interest benefits on subsidized loans. However, several lenders will delay the payoff of your original loans for as long as possible, to allow you to derive maximum benefit from the grace period on those loans. This involves exploiting the grace period loophole.

    Alternately, if you cannot begin repaying the consolidation loan because you are still looking for a job, you can apply for an unemployment deferment or an economic hardship deferment. These deferments allow you to delay repaying the loans for up to three years. Interest continues to accrue on unsubsidized loans, and must either be paid or added to principal through capitalization. (Note that you must continue making payments on the consolidation loan until your application for a deferment is approved. If you fail to make payments, your loan will go into default, and this will prevent you from obtaining a deferment.)

  • Loss of subsidized interest benefits on Perkins Loans. The interest benefits on a Subsidized Stafford Loan survive consolidation. This means that the federal government continues to pay the interest on the portion of the consolidation loan that resulted from the payoff of a subsidized Stafford loan while the borrower is in school or during other deferment periods. The interest benefits on a Perkins 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 and subsidized interest, borrowers who consolidate Perkins Loans also lose the Perkins Loan's favorable loan forgiveness provisions.

  • Extended Repayment is Optional, Not Mandatory. Extending the repayment term may increase the total interest paid over the lifetime of the loan.

    Some lenders have been encouraging (or at least, not discouraging) borrowers to obtain extended repayment on their consolidation loans. They do this in subtle ways, such as using a 20 year term instead of a 10 year term in their repayment examples.

    Borrowers are not required to pick an alternate repayment term, like extended repayment. Borrowers can stay with standard ten-year repayment even if they consolidate. We recommend keeping a standard repayment term, as this minimizes the total cost of the loan. You should only choose an extended or alternate repayment term when you are experiencing trouble making your monthly payments. The alternate repayment terms can reduce the size of the monthly payments by as much as 50%, but at a cost of increasing the total interest paid over the lifetime of the loan by as much as 250% or more. The alternate repayment plans can increase the cost of the loan by thousands or even tens of thousands of dollars.

    Lenders have a financial interest in encouraging borrowers to use alternate repayment. Lender profits are increased when borrowers have higher loan balances for longer terms. A 20 year term, for example, increases the average annual loan balance by about 10% as compared with a 10 year term, and doubles the repayment term. So the total interest paid is about 2.2 times higher on a 20 year term as compared with a 10 year term. Lender margins are tighter on consolidation loans, due to fees paid to the US Department of Education, so their annual profit on a consolidation loan is lower. However, if they can convince the borrower to use extended repayment, the total profits over the lifetime of the loan are higher.

    Some of the arguments lenders give in favor of extended repayment are reasonable. For example, if you have several forms of debt, you should use extra funds to pay off the more expensive (higher interest rate) debt first. This can save you money. You could extend the repayment term on your low cost federal student loans to reduce the size of the monthly payment, and use the savings to pay off your private student loans and credit card debt sooner. This can be part of a good debt management strategy that minimizes the total cost of all your debt. But it requires discipline, and extending the term on your education loans will increase their cost, especially if you fail to pay off your higher interest debt. So don't do this if you're just going to spend the savings.

    Another argument involves comparing the costs of interest on your student loans with stock market returns. If you have some extra money available, should you prepay part of your student loans, or invest the money in the stock market? Although the stock market has the potential for greater returns, it is also much riskier. Unless you have a lot of experience with investing, you are probably better off trying to pay off your debt as quickly as possible.

    After all, do you really want to still be paying off your own student loans when your children are ready to enroll in college?

  • You can only consolidate once. Current law allows borrowers to consolidate their loans only once. If you want to include a previous consolidation loan in a new consolidation loan, you must be adding other loans to the consolidation loan. Thus, your ability to use consolidation to switch from one lender to another will be severely limited after you consolidate, unless you held one or more loans out of the consolidation.

    Note that even if you are able to consolidate a previous consolidation loan, reconsolidation does not relock the interest rates on the existing consolidation loans. Once the interest rate on a consolidation loan is fixed, it does not change.

  • Inferior loan discounts. Lenders who offer borrower benefits for electronic funds transfer and making payments on time tend to offer less favorable benefits for consolidation loans. Most lenders offer a 0.25% interest rate reduction when you sign up to have your monthly payments direct debited from your bank account. However, the typical discount for making all of your payments on time is a 1% interest rate reduction after 36 months of on-time payments, instead of 2%. This is partly because the profit margins on consolidation loans are tighter than on unconsolidated loans. However, we expect to see increased competition on price among consolidators, now that the single holder rule has been repealed, so consolidators may soon start offering better discounts to encourage borrowers to switch lenders. Originating lenders and secondary markets may respond by improving the benefits for loans that remain unconsolidated.

  • Capitalization at Status Changes. Accrued interest on an unsubsidized 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, in section 428(b)(9)(A)(iv), allows borrowers to get extended or graduated repayment without consolidating their loans. The borrower must have accumulated more than $30,000 in federal education debt since 1998. The extended or graduated repayment plan may have a loan term of up to 25 years. Per the regulations at 34 CFR 682.209(a)(6)(ix), the borrower must not have 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 bill for all your loans from that lender.

Before July 1, 2006, married couples could jointly consolidate their loans. Although this could qualify the couple for a longer repayment term and lower monthly payments, it often caused problems when a couple got divorced later. By jointly consolidating the student loans, each spouse assumes full responsibility for repaying the debt. It is not possible to split up the debt during a divorce proceedings, so each spouse remains responsible for paying back the loans. If one ex-spouse fails to make a monthly payment, the other ex-spouse is responsible, and his/her credit record is affected. Similarly, the loan is no longer eligible for an in-school deferment, since both spouses must be enrolled in college for the loan to qualify for a deferment. (If one spouse dies or becomes permanently disabled, however, that portion of the debt is forgiven.) For these reasons, Congress repealed the ability for married borrowers to consolidate their loans together as part of the Higher Education Reconciliation Act of 2005.

Consolidating a fixed rate loan, such as a Perkins Loan, will not save you any money on the fixed rate loan. Consolidating does not reduce the underlying rate of a fixed rate loan, although it can increase it slightly, due to the rounding up to the nearest 1/8th of a point. (On the other hand, if the weighted average of the interest rates on the other loans would have resulted in the interest rate being rounded up nearly 1/8th of a point, including a fixed rate loan might mask some of the roundup, indirectly saving a little money. Likewise, if the weighted average was just below the 1/8th of a point boundary, including a fixed rate loan that bumps it over the 1/8th of a point boundary could increase the interest rate by up to 1/8th of a point beyond what it would have been otherwise. Thus including a Perkins Loan in a consolidation loan can cause the interest rate to be up to 1/8th of a percent higher or lower than it would otherwise have been, depending on whether it moves the weighted average of the interest rates closer to or beyond the next 1/8th of a percent boundary.) However, many banks provide a 0.25% reduction in the interest rate for signing up for automatic bank debit, which may make consolidating a Perkins loan financially worthwhile. (Note that there is a financial benefit to consolidating an 8.5% fixed rate PLUS loan, due to the lower 8.25% interest rate cap on consolidation loans.)

 

 
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