Consolidating student loans? Proceed with caution

Before Congress voted to impose fixed interest rates on federal student loans in July 2006, the decision to consolidate student loans and lock in at the lowest average variable rate was a no-brainer for most graduates, according to a recent report in the Christian Science Monitor, but in 2007 each graduate must weigh all of the consolidation options carefully. And if the President signs student loan legislation that was passed in Congress last Friday, future graduates with need-based Stafford loans will pay 3.4 percent, down from the current fixed rate of 6.8 percent for money they borrow over the next four years, making loan consolidation even more complex for students currently in school. The new bill, known as the Higher Education Access Act, also makes changes to repayment and forgiveness rules for future graduates depending on their income or employment in sensitive areas.

Interest Rates

Many 2007 graduates and some who are still in school took out Stafford loans with a fixed interest rate for at least one year and the pre-2006 variable rate for other years. Older Stafford loans with variable rates are reset in July of each year and are tied to the interest on three-month Treasury bills. Loans from private lenders not guaranteed by the government generally carry higher interest rates.

In today's interest rate environment, any student who still has federal variable rate loans should consolidate, says Rob LaBreche, president of consumer marketing for College Loan Corporation, a top student lender. "For students graduating this year, 3 out of 4 of their [Stafford] loans will still have variable rates."

Simplified Repayment

Saving money on interest is not the only reason graduates choose to consolidate, and about 70 percent of borrowers do – according to a report in The Wall Street Journal. Many who borrowed through Stafford loans have also borrowed from private lenders and are looking for simplified repayment options. Jason Myers, who graduated from Boston University in June, consolidated his Stafford loans last year before the program moved to the fixed rate, but he still needed a Stafford loan for his final year. He also has some unconsolidated private loans.

Myers cannot consolidate his new Stafford loan with the variable rate loans because a borrower can only consolidate a loan once. This rule applies to federal Stafford and Perkins loans, PLUS loans, and private loans. In addition, most experts recommend that borrowers consolidate federal and private loans separately, in order to get the most favorable rate and to keep some of the deferment and default provisions associated with federal loans.

Thus, in order to get the best rates, Mr. Myers will end up having to repay at least three separate loans and lose one of the major advantages of consolidation, the convenience of paying off a series of loans with just one or two checks.

Flexible Repayment Options

Recent graduates may want to consolidate because they find the monthly payments on their standard ten-year loans are just too high. Stafford loans must be paid back over a 10 year period, but consolidation can offer a longer term and thus lower monthly payments. Longer terms do, however, add to the interest costs of the loan. Both the Department of Education's Federal Direct Consolidation Loans web site and private lenders offer flexible repayment options.

Sallie Mae, the largest private student loan lender offers the following repayment options:

  • Standard repayment: monthly payments on a 10 year loan

  • Graduated repayment: Payments are lower at the beginning of repayment and increase at specific period over the term of the loan.

  • Income-sensitive repayment: Eligible borrowers base their initial monthly payments on a percentage of their income. Payments may be as low as 4 percent of the borrower's monthly income and can be periodically readjusted.

  • Extended repayment: Lengthened repayment terms of up to 25 years.

    Consolidating Federal and Private Loans

    Depending on the type of loan, consolidating the federal portion of student debt can involve more complex considerations than consolidating loans from private lenders. Perkins loans lose subsidized interest benefits after consolidation; the subsidized interest benefit survives with subsidized Stafford loans. Perkins loan borrowers lose their 9 month grace period and favorable loan forgiveness provisions. But since the consolidated loan is a new loan, it resets the clock on the term of a loan that is in repayment and also resets the clock on deferments and forbearances.

    Because Congress capped the fixed rate on federal loans at 8.25 percent in 2006, parent PLUS loan borrowers can benefit from a consolidation by having their interest rate reduced by .25 percent

    Private lenders, who often charge higher interest rates, like to see the terms of the loans extended in a consolidation because they will earn more money in additional interest. Many, however, offer benefits and alternative repayment plans that can be attractive to borrowers and in some cases can save them money. Private lenders will usually require a total of $7,500 of loan amounts for a consolidation loan.

    Private lenders may offer financial benefits for automatic payments and especially for on-time payment. But Mark Kantrowitz, founder of www.FinAid.org says that few graduates will ever see the return. Using statistics from Sallie Mae, according to the Christian Science Monitor, he calculates that less than one-quarter of borrowers make their first 36 payments on time, and less than 6 percent will pay back everything on time.

    Web sites like www.finaid.org, the student loan advice site; www.salliemae.com, the largest private provider of consolidation loans and www.loanconsolidation.ed.gov, the Federal Direct Consolidation Loan site, have calculators that help graduates interested in consolidating estimate their total costs and the value of any discounts. All three sites also provide a wealth of detailed information on loan consolidation.

    Impact of New Legislation

    The new student loan bill now on the President's desk would also cap loan repayments at 15 percent of borrowers' discretionary income, and allow borrowers in economic hardship to have their loans forgiven after 25 years. It will provide tuition assistance to undergraduates who commit to teach in high-poverty communities or high-need subjects. The law will provide public employees loan forgiveness after 10 years of service and loan repayment for military service and some occupations.

    The legislation will finance higher levels of Perkins loans and lower interest rates by reducing payments to lenders who service Stafford loans. Lenders have argued that this will cause financial hardship.

    The House passed the legislation with a vote of 292-97, and the Senate vote was 79-12 in favor. The President has indicated he will sign the bill.

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