If you have federal student loans and want to extend your repayment terms beyond the standard 10-year period, one of the options you might be considering is federal loan consolidation. While extending your repayment term will lower your monthly payment, federal consolidation won’t save you any money because your new interest rate will only be the average of your existing federal rates.
Federal Loans Use a Weighted Average
You have probably heard or read advertisements about how refinancing your mortgage, or even refinancing your student loans with a private lender, can save you money by getting a lower interest rate. That isn’t the case with federal student loan consolidation.
Your new consolidated interest rate is a weighted average & is actually rounded up to the nearest 1/8th of a percentage point (0.125%), meaning you will actually pay slightly more in interest than not consolidating.
For example, you may wish to consolidate two federal loans. The first loan has a balance of $8,000 and an interest rate of 3.76%. Your second loan has a balance of $10,000 and a 5.31% interest rate. The average rate of the two loans is 4.45%, but it would be rounded up to 4.5% since that is the nearest 1/8 of 1%.
Assuming you were to consolidate the loan and repay the balance in 10 years, the same amount of time as a non-consolidated loan, you would pay an additional $50 in interest approximately over the life of the loan. It might not make sense to consolidate unless you need more than 10 years to because of the slightly higher interest rate.
Benefits of Federal Student Loan Consolidation
The primary benefit to consolidating your federal loans is the option to retain the repayment and loan forgiveness options, even if you won’t save any money by getting a lower interest rate.
The primary benefit is the ability to retain the various income-based repayment plan & loan forgiveness benefits that private lenders do not offer. These benefits are ideal if you earn a low salary and need 20+ years to repay the balance, plan to volunteer with the Peace Corps or Americorps& receive federal loan credit for your service, or need to file forbearance because you lost your job and need to pause your payments until you start earning a steady paycheck again.
When refinancing with a private lender, you do not enjoy these repayment & forgiveness benefits. Although, some private lenders have begun introducing some these benefits recently to help in times of economic hardship.
How Federal Consolidation is Different from Private Refinancing
In addition to the repayment benefits, there are three large differences between federal consolidation loans and private refinancing.
Federal Consolidation Only Includes Federal Loans
Due to the various repayment benefits that federal loans enjoy, federal consolidation loans exclude private student loans because they do not have the same benefits. If you apply for a federal consolidation loan for your federal student loans, you will need to apply for a separate private refinancing loan for your private loans.
Private Lenders Will Bundle Federal Loans with Private Loans
Unlike federal servicers that will only consolidate federal loans, most private student loan refinancing companies will allow you to bundle your private and federal loans together. Doing so, means you have to forfeit the federal repayment and forgiveness options as the lender will pay the Department of Education the remaining balance for the federal loans and issue a new private loan for the same balance.
Once your federal loans have been privately refinanced, the process can never be reversed and they will remain a private loan forever. If you don’t plan on using those repayment benefits, it’s not a big deal to lose them if it means you can save some money from the third key difference between federal consolidation and private refinancing.
Private Refinancing Offers Lower Interest Rates
Private student loan refinancing does allow you the opportunity to save money with a lower interest rate with either a variable or fixed loan.
Variable rates and fixed interest rates are currently as low as 2.365% and 3.37%, respectively. It is possible to shave a few points off your current interest rate, and, you can save some additional money by making extra payments as most private lenders do not assess a prepayment penalty.
You may need a co-signer to with good credit to qualify for the lowest rates if you have little to no credit history. Usually, after 36 months of on-time payments, the lender will allow you to release your co-signer if desired.
Federal consolidation loans will not save you money because it’s impossible to get a lower interest rate than you are currently paying. But, they might be the better option if you need to utilize the repayment benefits or do not have a co-signer to help you qualify for the lowest private interest rates assuming you have a low credit score.
If you want to save money and can qualify for a lower interest rate, then private refinancing is the better option. And, you also have the option to combine your private and federal loans into the same loan giving the added advantage of a single monthly payment at the lowest possible interest rate.