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Interest Rate Loophole


This section of FinAid discusses a loophole that gives students who consolidate their loans before they enter repayment an effective interest rate reduction of 0.5% to 0.625%. With the switch from variable rate loans to fixed rate loans for new loans first disbursed after July 1, 2006, this loophole has been rendered ineffective for new borrowers. With new Stafford loans, the same interest rate is in effect during the in-school, grace and repayment periods.

When a student consolidates his or her loans, the weighted average of the interest rates is rounded up to the nearest 1/8th of a percentage point. A key consideration, however, is which interest rate is rounded up. If the student consolidates his or her loans before entering into repayment, the interest rate used is the in-school rate, which is lower than the rate used during repayment.

This loophole is clearly documented in the Federal Register, as excerpted below, and has been confirmed by direct communication with the US Department of Education. It is also mentioned in the "Dear Colleague" letter "GEN-99-17" and Direct Loan Bulletin "DLB-99-37", both of which incorrectly state that the benefit is available only to the Direct Consolidation Loan Program. Lenders are required to certify consolidated loans at the in-school rate if the application was submitted before entering repayment (e.g., during the in-school, grace or deferment periods), regardless of whether the loan is being consolidated into the FDSLP or FFELP programs.

The current in-school and repayment variable rate formulas are pegged to the 91-day T-bill rate plus margins of 1.7% and 2.3%, respectively. This yields a difference of 0.6%. Depending on the 91-day T-bill rate and the effect of the rounding, this can lead to an additional difference of -0.10% to 0.025%. Thus the total difference in interest rates for consolidated loans ranges from 0.5% to 0.625%. For example, in the 2000-2001 school year the in-school rate was 7.59%, and the repayment rate was 8.19%, a difference of 0.625% after rounding to the nearest 1/8th of a percent.

The savings over the lifetime of the loan can be substantial. The following figures assume an in-school rate of 7.625% and a repayment rate of 8.25% after rounding, and hence a difference of 0.625% in the interest rates. For a 10 year loan, this is equivalent to a savings of $39.62 per $1,000 borrowed over the lifetime of the loan. For a 15-year loan the savings increase to $64.84 per $1,000 borrowed. For a 20-year loan, $93.17 per $1,000 borrowed. For a 25-year loan, $123.34 per $1,000 borrowed. For a 30-year loan, $156.16 per $1,000 borrowed. Thus this will save students hundreds or even thousands of dollars over the lifetime of their loans. For example, a student who has $16,000 in loans and consolidates at the in-school rate for a 25-year term will save $1,982.71 over the lifetime of the loan.

It is worth noting that consolidating a loan locks in the interest rate for the lifetime of the loan. This is in contrast with unconsolidated loans, which use a variable rate that changes each July 1. Thus a student who intends to consolidate his or her loans should preferentially consolidate before entering repayment, in order to lock in the lower interest rate.

If a borrower's application is received before the student graduates or drops below half-time, the borrower automatically receives their six month grace period. (The US Department of Education has confirmed this for the Direct Loan Consolidation Program. It probably also applies for FFELP loans.) Nevertheless, we recommend that students who intend to consolidate before their loans enter repayment do so no later than the third or fourth month of their grace period, to ensure that the certification occurs before they enter repayment.

Students at Direct Loan schools can consolidate while they are still in school to lock in the lower in-school rate, in addition to during the grace period. (This provision was repealed effective July 1, 2006.) Students with bank-based loans from the FFEL program, however, can only lock in the lower in-school rate during the grace period, since they cannot consolidate while they are still in-school. (Students in the FFEL program who have at least one Direct Loan, however, may obtain a Federal Direct Consolidation Loan, and use it to lock in the lower in-school rate before graduation.) However, a loophole discovered in 2005 allows students in the FFEL program to request early repayment status while they are still in school. This allows them to consolidate while they are still in-school. If they ask for an in-school deferment after receiving early repayment status, the loans will be consolidated at the in-school rate. (This loophole was closed effective July 1, 2006 by the Higher Education Reconciliation Act of 2005.)

Treatment of Interest Rate Reductions

Another issue is how the weighted average of the interest rates is affected by incentive programs such as interest rate reductions for prompt payment. The Federal Register excerpt does not explicitly state whether it is the "applicable rate" or the "actual rate" as defined in the various statutes and regulations. The word "apply" suggests the former, while the word "current" suggests the latter.

However, the law is quite clear in describing the interest rate with respect to consolidation as an "applicable rate" and not an "actual rate". For example, 682.202(a) says that "The applicable interest rates for FFEL Program loans are given in paragraphs (a)(1) through (a)(4) of this section." Section 682.202(a)(4) describes the interest rates for consolidation loans, and in particular, 682.202(a)(4)(iv) describes the formula for calculating the interest rate on consolidation loans. In contrast, a description of actual interest rates is described in Section 682.202(a)(5), and explicitly refers to the rates in 682.202(a)(4) as applicable interest rates: "A lender may charge a borrower an actual rate of interest that is less than the applicable interest rate specified in paragraphs (a)(1)-(4) of this section." Thus it is clear that the interest rate used in computing the weighted average during repayment is the applicable rate and not the actual rate, and so does not include any of the lender's voluntary interest rate reductions. The lender may, of course, choose to apply such prompt payment discounts and interest rate reductions to the loan after consolidation, as per 682.202(a)(5).

Excerpt from Federal Register

The following text is excerpted from the Federal Register, Volume 64, Number 210, dated November 1, 1999.

Comment: In response to the Secretary's request for comments on how to make these proposed regulations easier to understand, a major association representing credit unions suggested that for clarity, we provide an example to clarify the regulatory requirement to use weighted average interest rates for Consolidation loans.

Discussion: The weighted average interest rate used for Consolidation loans in both the FFEL and Direct Loan programs should be calculated based on the interest rates that apply to the loans being consolidated at the time the loan holders complete the verification certificates. In making the calculation, it is important to note that an interest rate that is lower than the repayment period rate applies to most subsidized and unsubsidized Stafford loans in the FFEL and Direct Loan programs during the in-school, grace, and deferment periods. This affects the calculation of the weighted average interest rate. If, for example, a loan is in a grace period at the time the loan holder completes the verification certificate, the lower grace period interest rate would be used in the calculation of the weighted average interest rate on the Consolidation loan. Conversely, if the borrower applies for a Consolidation loan after entering repayment on a loan, the higher repayment interest rate of the loan being consolidated would be used in calculating the weighted average interest rate on the Consolidation loan.

The weighted average interest rate is a single interest rate that is calculated by using the borrower's loan balances and the current annual interest rate for each of the borrower's loans.

For example: A borrower has two subsidized Federal Stafford Loans, one for $10,000 and the other for $5,000, both with an interest rate of 8.25 percent. The borrower also has a $3,500 unsubsidized Federal Stafford Loan with an interest rate of 7.46 percent and a $3,000 Federal Perkins Loan with a 5.0 percent interest rate. The borrower consolidates these loans.

The following steps outline one way to calculate the weighted average interest rate:

  1. Multiply the balance of each loan being consolidated by the interest rate that applies to that loan at the time the verification certificate is completed.
  2. Add the calculated interest amounts for all loans being consolidated ($1,648.60).
  3. Add the loan balances for all loans being consolidated ($21,500).
  4. Divide the sum of the calculated interest amounts by the sum of the loan balance amounts (7.66%).
  5. Round the quotient (the answer to Step 4) to the nearest higher one-eighth of one percent (7.75%).
  6. Compare the result in Step 5 to the 8.25% maximum interest rate and determine which is lower. The lower of the two rates is the borrower's fixed interest rate for the Consolidation loan.

The weighted average interest rate for the borrower in this example is 7.75%.

Change: None.


Thanks to Phil Schrag, Bob Sandlin, and Karen Epps for help identifying and confirming this loophole.


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