Is Student Loan Consolidation Right for You?

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College students are facing a harsh reality upon graduation: massive student loans and a feeble labor market.

For the first time ever, the amount of loans students took out last year crossed the $100 billion mark, according to the Federal Reserve Bank of New York. Outstanding student loan debt is expected to add up to more than $1 trillion in 2011.

Defaulting on a loan can damage a grad's financial life, before it ever really gets started, making it essential for them to make a plan to pay off their loans.

There are many options for students to repay their student loan debt and some students may choose consolidation, combining their various loan amounts and interest rates into one monthly payment.

The interest rates on student loans vary by the type of loan and date of disbursement. According to Haley Chitty, director of communications for the National Association of Student Financial Aid Administrators, the following loans are currently at these interest rates:

•Unsubsidized Stafford Loans for undergraduate students and Subsidized Stafford Loans for graduate and professional students have a 6.8% interest rate (beginning July 1, 2012, graduate and professional students can no longer get Subsidized Stafford Loans. Subsidized Stafford Loans for undergraduate students have a different interest rate depending on when they were disbursed)

•4.5% for loans disbursed between July 1, 2010 and June 30, 2011

•3.4% for loans disbursed between July 1, 2011 and June 30, 2012 (the current rate)

•The rate is scheduled to increase to 6.8% for Subsidized Stafford Loans disbursed on and after July 1, 2012

•Federal Perkins Loans have a 5% interest rate'

•PLUS Loans have a 7.9% interest rate

To calculate interest for consolidated loans, the weighted average of the interest rate on the loans a student is consolidating is rounded up to the nearest 1/8% and is capped at 8.25%.

Because federal student loan regulations are constantly changing, the terms of students’ loans may depend on when the money was borrowed.

“People who borrowed student loans before 2006 may have gotten some federal student loans that were at very low interest rates,” says student loan expert Heather Jarvis. “The current prevailing rates are going to make a difference—[graduates] could lock in one of those low rates rather than waiting because they’re likely to go up over time.”

It’s important for borrowers to understand whether or not they have variable interest rate loans, which can affect the timing for consolidation, says Jarvis.

“They want to be clear on what their repayment options will be and they also will want to make decisions about which loans to consolidate if they have multiple loans because they can choose to consolidate them all or not,” she says.

For students with private loans, it can be more difficult to get a consolidation loan because not many companies still offer this option. Chitty explains that interest rates on private student loans are based on borrower’s credit score, but if a student’s score has improved significantly since the loan was obtained, that could lead to a lower rate.

Jarvis emphasizes that there are multiple benefits associated with federal student loans that are not available with private loans. Although some private loans may have a lower interest rate, they are usually loaned at variable rates.

“[These rates] are low now, but often have no cap and are very likely to rise over time,” says Jarvis. “Those loans also don’t have the same borrower protections or flexible repayment options that federal student loans have.”

Although students can no longer consolidate their loans while still in school, Jarvis explains that they can take advantage of the “grace period” of their loan repayment--usually six months to a year after graduating.

“If you consolidate your student loans, they do enter repayment status at that point,” she says. “You could end up forgoing some of your grace period and that may or may not be a good idea based on your circumstances.”

Pros of Consolidating Loans

For student with multiple loans from different lenders, consolidation gives them the advantage of having all of their loans in one place, simplifying the payment process by making one repayment per month instead of several, says Howard Dvorkin, founder of Consolidated Credit Counseling Services.

Loan consolidation an also give borrowers a longer term of repayment, which can be useful for students struggling to find work out of.

“If you owe up to $60,000 or more, you can have 30 years to pay--that’s a big reason why people would typically consolidate,” says Jarvis.

Chitty points out that by consolidating federal loans, borrowers can become eligible for income-based repayment and possible loan forgiveness.

“For private loans, there may be an opportunity for those who have improved their credit score to lower their interest rate,” he says. “This could also provide leverage to negotiate with the current loan holder who may agree to better terms so they don’t lose the loan.”

Cons of Loan Consolidation

Depending on their financial situation after obtaining a diploma, students may be doing themselves a disservice by stretching their payments out longer. A longer repayment period may bring a lower interest rate, but students can actually end up paying more in interest.

“They need to ask what’s the rate and they have to understand the term because $600 a month sounds better than $800 a month, but you’re paying it for 20 years versus 10—are they really doing themselves a favor?” says Dvorkin. “Because you can stretch the consolidated loans out for up to 30 years in some cases, in the long run you’re going to end up paying more depending on what your time horizon is.”

Jarvis explains that borrowers should understand that consolidating is not comparable to refinancing your house for a better rate.

“That used to be true when people were borrowing at variable rates. Now they’re getting a fixed rate set by law and that doesn’t get any better just because they consolidate,” says Jarvis.

Students that decide to consolidate loans after repaying them consistently for a period of time can lose any interest rate reductions or borrower incentive advantages that they’ve earned.

Questions Students Need to Ask Lenders

Before making any kind of decision, the experts suggest that students talk to their lenders and ask some important questions:

“How much will monthly payments be? What is the overall cost of the loan? Are there any repayment benefits or incentives [some lenders reduce the interest rate for on-time payments]? Will they lose any benefits by consolidating? What is the interest rate and is it a fixed or variable rate? Are there any loan fees? Are there any penalties for paying off the loan ahead of schedule?” says Chitty.

For private loans, students should also ask whether the interest rate is fixed or variable, if there are any fees, and whether there are prepayment penalties.

“Borrowers need to compare the terms and benefits of their current loans with the consolidation loans—[they] can lose out on benefits or repayment incentives like a lower interest rate if they consolidate,” says Chitty.

The experts recommend that students that are fiscally able, pay more toward student loans every month to stay on top of their debt and avoid tarnishing their credit history.

Student loan regulations are constantly changing, so students need to stay informed with the interest rates their lender charges, and the terms and conditions of their loans.

"You’ve got to be very careful about what you’re getting into,” says Dvorkin. “This is a moving target.”

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