Your Money: Careful when consolidating student loans

If you plan to graduate from college this spring, your mailbox may soon be filled with congratulatory cards from family friends, checks from distant relatives and reminders from your alma mater that your diploma will be rescinded unless you pay your overdue parking tickets. But if you borrowed to pay for college, much of your mail will come from lenders, urging you to consolidate your student loans.
Loan consolidation pitches aren't new. For years, loan consolidation has allowed borrowers to reduce their monthly payments and avoid interest-rate increases. But lenders will be even more aggressive this year than in the past, predicts Kevin Walker, CEO of SimpleTuition, a loan comparison website.

In part, that's because a law enacted last year eliminated the decades-old "single-holder" rule. That rule required borrowers who had all their federal student loans with one lender and wanted to consolidate to use that lender. Now, borrowers can consolidate with any lender. Smaller lenders are eager to lure student loans from the major players, Walker says.

In addition, lenders will have to work harder this year to convince borrowers that they should consolidate their loans. In the past, consolidation let borrowers lock in interest rates for the life of their loans, avoiding future increases. But last year, Congress eliminated variable rates for federal Stafford loans. All loans issued after July 1, 2006, have a fixed rate of 6.8%, so consolidating no longer affects the interest rate those borrowers will pay.

Why consolidate?

While there are still advantages to loan consolidation, recent investigations into some lenders' marketing tactics have pointed up the need for vigilance. Rep. George Miller, D-Calif., chairman of the House Education and Labor Committee, has asked the Federal Trade Commission to investigate "unfair and deceptive" marketing practices by lenders seeking to consolidate student loans. And New York Attorney General Andrew Cuomo is investigating whether some college alumni groups received payments from Nelnet, a major loan consolidator, to steer students to Nelnet.

Reasons to consider loan consolidation:

•You still have variable-rate loans. Unless they've already consolidated, this year's graduating seniors will have a combination of variable-rate and fixed-rate loans, says Rob LaBreche, president of consumer marketing for College Loan Corp. By consolidating, you can lock in the rate on the variable-rate loans, avoiding future rate increases.

If you consolidate your variable-rate loans during your grace period — the six-month window before you're required to start paying off your loans — you can lock in a rate of 6.54%. If you include your fixed-rate loan in the consolidation, your rate will be 6.875%, Walker says.

The new rate for variable-rate loans, which is tied to short-term Treasury bills, will be calculated at the end of May. Mark Kantrowitz, founder of FinAid.org, predicts that the repayment rate for variable-rate Stafford loans will rise to 7.2% on July 1. But many lenders let you hedge your bets. Lenders with "best rates" programs will accept your application but won't process it until the new rate is determined. If the new rate is higher, they'll consolidate your loans before July 1; if the rate falls, they'll wait until after July 1.

•Lower payments. The standard repayment for a federal Stafford loan is 10 years. By consolidating, you can extend the term to up to 30 years, thereby reducing your monthly payments.

If you're worried that you can't afford your monthly payments, consolidating will make your debt more manageable. It's important to understand, though, that extending the term of your loan will increase the amount of interest you'll pay over the course of the loan. Ideally, you should increase your monthly payments as soon as your finances improve.

•Fewer bills to pay. If you have loans with several lenders, consolidation allows you to combine them into one loan.

•Borrower benefits. Even though the maximum rate for Stafford loans is set by the federal government, some lenders offer discounts for good behavior. Most will cut your interest rate by a quarter point if you agree to have your payments automatically deducted from a bank account. And many will reduce your rate by 1 percentage point once you've made a certain number of consecutive on-time payments (see box).

If your current lender doesn't offer discounts, consolidating with a lender that does could save you money. But be sure to read the fine print, Walker says. Ask the lender how it defines an on-time payment and whether your discount can be revoked if you make a late payment in the future.

"Borrower benefits have the potential to save you hundreds, if not thousands, of dollars," Kantrowitz says. "But you need to be very realistic about your ability to get those benefits."

by Sandra Block