Ask Cappex: Do Consolidation Loans Save Money?

on June 16, 2017

Our college expert Mark Kantrowitz answers your questions about college admissions and financial aid.


Q. Do consolidation loans save money?


A. Whether consolidation loans save borrowers money depends on the type of consolidation loan (federal vs. private) and borrower-specific details.


Federal consolidation loans previously saved borrowers money by letting them lock in a low interest rate on their federal student loans. The savings came from comparing the locked-in interest rate with potential subsequent increases in variable interest rates, had the loans not been consolidated.


Federal student loans were made with variable rates before July 1, 2006. Interest rates during the in-school and grace periods also were 0.6 percent lower than during the repayment period. Consolidating these loans during the in-school and grace periods yielded a fixed interest rate based on the applicable interest rate at the time the loans were consolidated.


Ever since July 1, 2006, however, federal education loans have had fixed rates, so consolidation is no longer needed to lock in a fixed interest rate.


Moreover, federal consolidation loans can increase the borrower’s costs. The interest rate on a federal consolidation loan is based on the weighted average of the interest rates on the loans included in the consolidation loan, rounded up to the nearest eighth of a point. Even though the new interest rate is usually between the highest and lowest rates among the loans that were consolidated, rounding up to the nearest eighth of a point increases the cost of the loans.


Consolidating loans also increases costs by replacing multiple loans with a single loan. This prevents you from saving money by targeting the highest-rate loan for quicker repayment.


Even though federal consolidation loans no longer save borrowers money, a myth developed because they previously provided a financial benefit. Also, some lenders characterized consolidation loans as saving money because the choice of a longer repayment term reduced the monthly payment. A longer repayment term means more payments and more interest so the lower monthly payment does not save money.


For example, increasing the repayment term on a $10,000 loan at 6 percent from 10 years to 20 years might cut the monthly payment by about a third from $111.02 to $71.64, but it more than doubles the total interest paid over the life of the loan, from $3,322.48 to $7,195.04.


A private consolidation loan, on the other hand, might save the borrower money, or it might not, depending on the details.


Private consolidation loans are more like a traditional refinance, where the borrower receives a new loan with a new interest rate based on the borrower’s current credit score. If the borrower’s credit scores have improved since the borrower obtained the loans, a private consolidation loan might yield a lower interest rate, saving the borrower money.


Typically, a borrower’s credit scores reach their lowest point soon after graduation, since the credit scores decrease each year the borrower is in college due to greater credit utilization. If the borrower obtains a private consolidation loan a few years after graduation, the borrower might qualify for a lower interest rate, if the borrower has been managing his or her credit responsibly.


More than 90 percent of private student loans require a cosigner. The original interest rates were based on the higher of the borrower’s and cosigner’s credit scores. So, if the borrower refinances their private student loans without a cosigner, the borrower might not qualify for a lower interest rate, even if the borrower’s credit scores have improved. The borrower must beat the cosigner’s credit score, not just their own previous credit score.

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