The Consolidating Student Loans Not Always Best Option

WHEN IT WAS first introduced in the mid-1980s, student loan consolidation was touted as a much-needed solution for those struggling to pay their debts from college. Borrowers could combine their Stafford and Plus loans into one payment and lock in the prevailing interest rate — typically, one lower than the average rates that they were previously paying on their other loans.

Times have changed, however, and consolidation is no longer the cheap and attractive option that it used to be. Thanks to the declining federal funds rate and the phasing out of variable-rate loans, consolidating your student loans now will actually cost you more over the lifetime of the loan. Eventually, consolidation will come back into fashion for variable-rate loans (rates should be much more attractive when they reset in July). But it will probably never again be the least-expensive solution for those with fixed-rate loans.

Here are some ways borrowers can ensure they're getting the best deal. (We've included a glossary of student loan terms to help you along the way.)


Hold Onto Variable-Rate Stafford & Plus Loans for Now
If you're currently making payments on a variable-rate Stafford or Plus loan, don't consolidate for at least a few months, says Mark Kantrowitz, publisher of FinAid.org, an online source for student financial aid information.

Here's why: Federal loan interest rates are tied to the investment rate of the 91-day Treasury bill. To establish the price of the T-bill, auctions are held on a weekly basis. The last auction to occur in May of each year sets the base rate for student loans for the upcoming academic year and goes into effect come July 1. Last year's May 29 auction ended with a T-bill investment rate of 4.9%.

On top of the base rate, an additional interest rate gets tacked on to establish the federal student loan rates. For example, a 1.7% rate was added to the 4.9% to create the current interest rate for Stafford loans in the grace period (a grace period lasts up to six months after graduation). For Stafford loans in the repayment period, which starts once the grace period expires, a 2.3% rate was added to the base rate.

Since July 1 last year, the Federal Reserve has cut the fed-funds rate six times. These cuts have dramatically lowered the T-bill investment rate, which moves in tandem with the fed-funds rate. At the latest auction on March 17, the T-bill investment rate dropped to a mere 1.12%.

On the surface, this appears to be great news for those looking to consolidate. The problem is that any student consolidating now will be stuck paying the higher rate from last year.

Say you have a Stafford loan that's in the repayment period: Your rate is 7.22%. Consolidate now and you'll end up paying a slightly higher 7.25%. Wait until July 1 to consolidate, however, and rates will be near historic lows, says Kantrowitz. The chart below gives you an idea of how much borrowers holding variable rate loans can save if they wait until on or after July 1 to consolidate:

Don't forget that you have a month between the end of May when the base rate is set and July 1 when the new student loan rates go into effect to weigh your options. "If the impossible happened and...the T-bill rate was [rising], you'd...have the month of June to consolidate your loans with the old rates," says Sallie Mae spokesperson Martha Holler.


Don't Consolidate Fixed-Rate Loans
In the past, all student loans came with variable rates. If a borrower had difficulty making their payments, they could consolidate their loans into one low fixed-rate loan.

But as of July 1, 2006, every Stafford and Plus loan now carries a fixed interest rate, making it unnecessary to consolidate in order to lock in a set rate. In fact, borrowers who have fixed-rate loans should never consolidate them. If they do, they'll end up with a higher interest rate than they're already paying. Under consolidation, the interest rate will be the weighted average of the rates of the loans being consolidated, rounded up to the nearest 1/8 of 1%.

Subsidized Stafford loans taken out for the 2007-08 academic year carry an interest rate of 6.8%; the rate for 2008-09 loans is 6%, and for 2009-10, 5.6%. Unsubsidized loans will still carry a 6.8% fixed rate indefinitely. For Plus loans sold through the Direct Loan program, rates are fixed at 7.9%. Plus loans dispersed through the Federal Family Education Loan (FFEL) program carry an 8.5% rate.

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