Consolidating Student Loans Can Offer Relief From Looming Interest Rate Hike

Student loan borrowers who want to head off higher interest costs need to work fast.

Rates on many federal student loans are scheduled to rise Saturday by about 1.25 percentage points. The hike could add $20 a month to a $30,000 loan, or $2,400 over a 10-year term.

Thousands of borrowers are rushing to apply for consolidation loans that would essentially lock in their current rates--and perhaps give new graduates some financial breathing room as well.

“It can mean a good deal of [savings] for someone just starting out in the workplace,” said Stephanie Babyak, spokesman for the U.S. Department of Education, which has seen consolidation applications more than double to 7,300 a week, contrasted with 3,500 a week at this time last year.

Consolidation can also be smart for borrowers with older student loans that have high rate caps. While newer federal loans are capped at 8.25%, for example, older loans may have caps of up to 12%, making a fixed-rate consolidation loan more attractive now.

Most federal student-loan rates are variable and are adjusted annually on July 1 using a formula that factors in yields on 91-day Treasury bills in May. Those rates have spiked by 1.25% since last year, as the Federal Reserve has driven up rates in general.

Rates on federal Stafford loans will rise from their current levels of 6.32% to 7.72%, depending on when the loans were made or when the borrower started school, to between 7.59% and 8.99%. Federal PLUS loan rates currently range from 7.72% to 7.98% but will rise to between 8.99% and 9.48%.

Consolidation loans offer borrowers the chance to refinance their old, variable-rate loans into one fixed-rate repayment plan. Federal loan consolidation plans offered by the Department of Education and student lenders such as Sallie Mae, Nellie Mae and USA Group compute the new fixed rate by using a weighted average of the rates on the borrower’s existing loans, then rounding the figure up to the nearest one-eighth percent. The maximum rate is 8.25%.

Many loan consolidators have made changes to accommodate the rush. For example, the federal Direct Loan Consolidation program revised rules that used to delay the determination of the consolidation loan’s rate until the day the original lenders certified, or signed off on, the loan refinancing. That process often takes a week or more from the date the borrower applies.

Now, anyone whose application is postmarked by midnight Friday--or who applies before then on the Department of Education’s Web site (https://www.loanconsolidation.ed.gov)--will qualify for the lower rate.

Sallie Mae, Nellie Mae and USA Group also guarantee the lower rates for borrowers who apply by midnight Friday.

Consolidation can have another advantage for cash-strapped new graduates, although the benefit comes with a price. Consolidation loans often are used to stretch out a borrower’s payment plan from the usual 10-year term to 20 or 30 years. The longer plans lower the borrower’s monthly payment--though they can dramatically increase the total cost of the loan.

For example, a 10-year repayment schedule for a $30,000 loan would require monthly payments of about $356, for a total cost of about $43,000. A 20-year repayment at the same interest rate, 7.5%, would have monthly payments of $242 but a total cost of more than $58,000--nearly double the amount originally borrowed.

Borrowers often can reduce their monthly payments even more by opting for graduated or interest-only plans that offer lower payments for the first two to four years, followed by higher payments until the end of the loan.

Borrowers who are unsure of their ability to repay or whose incomes are irregular may want to consider a consolidation with a 20-year or 30-year term, especially if their lender does not levy prepayment penalties. That way, borrowers can make bigger payments when income allows, while keeping a low minimum payment should they fall on hard economic times.

“If you get a raise, you can increase the payments,” said Nina Prikazsky, Nellie Mae vice president of operations. “You can always pay as much principal as you want.”

Consolidation loans do have disadvantages, however:

* Not all consolidation programs are created equal. Federal loan consolidation programs offer the lowest rates and most advantageous terms, but private student loans and other debt aren’t eligible for consolidation under these programs. Borrowers with private student loans should contact their lenders to see whether consolidation is offered and under what terms.

Also, some private companies allow borrowers to consolidate student loans with credit card and other debt, but the terms are generally not as advantageous as those through federal programs.

* Consolidation loan rates don’t vary, which is an advantage when rates are climbing but may be a disadvantage if rates fall. Generally, you can refinance a federal consolidated loan only if you acquire or fold in another student loan. That means most graduates will be stuck with the consolidated loan they get now. If interest rates drop sharply in coming years, you won’t be able to take advantage of better rates.

* Because they replace the underlying loans, consolidation plans may wipe out special benefits offered by the original loans. For example, lenders, including Sallie Mae, usually reduce interest rates on regular student loans by 2 percentage points after 48 months of on-time payments. The benefit, which can reduce costs considerably, is not available with consolidation loans.

So people with a good on-time payment history who qualify for the rate reduction, and who otherwise can afford their loan payments, may want to avoid consolidation, especially if their loan interest rates are capped at 8.25%.

In addition, federally subsidized student loans offer the option of having the government pay your interest should you return to school or otherwise have to defer payments. A consolidation may eliminate this feature; borrowers should check with their lenders, and consider leaving subsidized loans out of their consolidation program if they would lose the benefit.