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Does Consolidating Student Loans Save Money Like a Refinance?

Mark Kantrowitz

May 16, 2011

I have a question concerning consolidating my federal loans. I have some that are subsidized and some that are unsubsidized. Can I combine these at a lower interest rate? I have graduated from college and will soon be starting to pay back my loans. My unsubsidized loans are at 6.8% and subsidized are at 5.5%. I also have many DEAL loans, a total of $25,000. Do you have any suggestions on how I could save on these loans? They are at various interest rates. — Denise G.

Consolidating your federal student loans may streamline repayment by replacing several loans with a single loan and a single monthly payment, but it will not save you money. Consolidation may have saved borrowers money in the past, but it no longer does so.

Federal education loans made before July 1, 2006 had variable interest rates. Federal consolidation loans could be used to lock in the current interest rates on the variable rate loans since a consolidation loan has a fixed interest rate based on the current interest rates of the loans being consolidated. To the extent that the borrower was able to lock in a low interest rate, this would save money compared with the maximum possible variable interest rate. For example, Stafford loan borrowers in 2005 could consolidate their loans during the in-school or grace periods to lock in an interest rate of 2.875%, much lower than the 8.25% cap on the variable interest rates.

But federal education loans made on or after July 1, 2006 have had fixed interest rates. There is no longer any opportunity to use consolidation to lock in an interest rate, since the interest rates on these loans are already fixed. The fixed interest rate on the unsubsidized Stafford loan since July 1, 2006 is 6.8%. The fixed interest rate on the subsidized Stafford loan depends on the academic year in which the loan was originated, with loans made in 2006-07 and 2007-08 at 6.8%, in 2008-09 at 6.0%, in 2009-10 at 5.6%, in 2010-11 at 4.5% and in 2011-12 at 3.4%. (New subsidized Stafford loans in 2012-13 and subsequent years will be at 6.8%.) Your subsidized Stafford loans are probably at either 5.6% or 4.5%, not 5.5%.

A federal consolidation loan has a fixed interest rate that is the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest 1/8th of a point. The weighted average will always be between the highest and lowest interest rates. So while one could characterize the weighted average as reducing the interest rate on the loan with the highest interest rate, one could also say that the weighted average increases the interest rate on the loan with the lowest interest rate. It is not like a traditional refinance where one can get a new, less-expensive loan after interest rates drop enough to make the refinance worthwhile. The use of the weighted average in a federal consolidation loan does not significantly change the overall cost of the set of loans being consolidated.

Note that borrowers who consolidate their federal student loans often choose an extended repayment term. While this may make the loan more affordable by reducing the monthly payment, it does not save money because it increases the total interest paid over the life of the loan. For example, increasing the term on an unsubsidized Stafford loan from 10 to 20 years cuts the monthly payment by a third, but more than doubles the total interest paid (a factor of 2.18 increase).

A borrower might still want to consolidate their federal education loans to simplify repayment. Some lenders offer unified billing, where the borrower gets a single monthly bill for all their loans without consolidating. But all of the borrower’s loans have to be with the same lender. Many borrowers graduating now have a mix of several types of loans, including loans from the federally-guaranteed student loan program (FFELP) and loans from the Direct Loan program, as well as FFELP loans that were sold to the US Department of Education. These loans cannot be serviced together, so consolidation presents the only opportunity to get a single monthly bill. (Borrowers might also want to consolidate their federal loans to get public service loan forgiveness or to get access to certain alternate repayment plans.)

But there are also benefits to keeping the loans separate. If you have several loans at different interest rates, keeping them separate allows you to target the loans with the highest interest rates for earlier repayment. (There are no prepayment penalties on federal or private student loans.) You should always make the required monthly payments on all your loans. But if you have some extra money, using it to accelerate repayment of the highest interest rate loan first will save you more money than if you accelerate repayment of a consolidation loan.

For example, suppose you have $11,820 in 6.8% loans and $10,000 in 5.6% loans. A consolidation loan would have a 6.25% interest rate on the combined balance of $21,820. (The loan balances in this example were picked to ensure that the consolidation loan would have an interest rate that would not change with the rounding up to the nearest 1/8th of a point.) Assuming a 10-year repayment term with an extra $50 a month prepayment, applying the extra payment to the 6.8% loan saves about $121 more than applying it to the consolidation loan.

Since July 1, 2010, only the Federal Direct Loan program can consolidate federal education loans. Visit loanconsolidation.ed.gov or call 1-800-557-7392 (TDD 1-800-557-7395) to consolidate federal education loans.


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