Consolidating Student Debt No Longer a No-Brainer

Higher interest rates and new rules have eliminated some benefits of loan consolidation.
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College seniors are graduating this month, but there's still one more lesson to go.

They're about to get a crash course in personal finance as they consider whether to consolidate the multiple student loans they've taken out over the past four years. And the process is a lot more complex than it used to be.

Mark Kantrowitz, who advises student borrowers through his Web site

finaid.org, says combining all your federally guaranteed student loans used to be a "no-brainer." As recently as a year ago, you could lock in historically low interest rates, enjoy the convenience of a single monthly bill and perhaps even extend your repayment period.

Now, higher interest rates and rule changes have altered the landscape.

Many borrowers saw the changes coming and have already consolidated -- some before they even graduated. Those who didn't now face less attractive options. Kantrowitz says he recently worked with a student who passed up the opportunity to consolidate her $60,000 in debt at an interest rate of 2.88%. Now she is paying 6.83%.

"I would have thought that everybody who could consolidate did so," Kantrowitz says.

At this point, there is no longer any need to rush. Borrowers normally try to consolidate before interest rates on these loans reset at the beginning of July. (The new rate is based on the results of the last Treasury bill auction in May.) However, this year's hike will be a modest one. The rate for Stafford loans is set to go up just 8 basis points to 7.22% from 7.14%. Parents with PLUS loans will see the same small increase, going to 8.02% from 7.94%. For most borrowers, this difference amounts to just a few dollars over the life of the loan.

However, if you just graduated, you should still make your move within six months so you can get the in-school interest rate, which is 0.6% lower than what you get when the grace period runs out.

Borrowers looking to consolidate their student loans right now have a lot of offers to choose from. That's because the federal government has eliminated the so-called "single holder rule" that forced students who had taken out multiple loans with one lender to consolidate with that same company.

Now that you can look around, lenders are using special offers to attract your business. That means comparing base interest rates won't tell the whole story. For example, one lender might discount your rate an additional 0.25% if you have your payment automatically debited from your bank account. Another might knock off an entire percentage point after 36 months of on-time payments.

Such incentives make picking the right consolidation loan more complicated. Finaid.org's Kantrowitz recommends looking for discounts that are available immediately or easy to obtain. A quick interest rate reduction for auto-debit may be more valuable than an on-time payment incentive that kicks in late in the life of the loan after much of the principal has been paid off.

This is especially true when you consider that many borrowers overestimate their ability to avoid late payments. "The No. 1 problem students have is forgetting to notify their lender when they move," Kantrowitz says. "They lose it during the very first month."

Another rule change should make consolidation simpler in the future. Congress has fixed the rate on Stafford loans made after July 1, 2006, at 6.8%, meaning you won't need to combine your loans just to lock in a favorable rate. PLUS Loans disbursed after this date will be fixed at 8.5%.

Still, consolidation will remain an appealing option for many borrowers who want to stretch out their repayment period in order to lower their monthly bill. However, be cautious, because it can end up costing a lot of money.

For example, for a hypothetical $10,000 loan with an interest rate of 6.9%, you would pay $3,855 in interest if you pay it back in 10 years. But if you extend the repayment period to 15 years, the amount of interest you pay would jump to $6,052. While having a smaller monthly payment can free up money to deal with other immediate needs, it may worth doing a little budgeting to pay a student loan back quicker -- and you can always opt to change the repayment period at a later date.

Another thing to consider - you may not want to consolidate all of your loans. Interest rates on consolidation loans are determined by taking the weighted average of the rates for all the loans being paid off and rounding it up to the nearest 1/8th of a percent. For example, if the weighted average rate on your loans is 6.2%, you will end up paying 6.25%. So if your bigger loans carry higher interest rates, you might not save that much money by combing them with smaller loans that pay lower rates.

The math can be tricky, but you can save money by coming up with a combination of loans that puts you just below or exactly at the 1/8th of a point boundary.

The recent scandals in the news involving the student loan industry may have you wondering who you can trust for unbiased information about lenders and their products. Kantrowitz says financial aid departments at colleges and universities still represent "a good starting point."

In fact, after all the media and regulatory scrutiny, they may actually be a better source of advice. "Every school is taking a very close look at their preferred lender list," Kantrowitz says.