debt

What to know about consolidating student loans

Highlights
  • Federal loan consolidations cap at an 8.25 percent rate.
  • Consolidating is combining all your loans into one "megaloan."
  • Don't combine federal and private student loans if you can avoid it.

Just yesterday, they were applying to college. And now they've graduated. Along with gaining a new degree, many graduates will also leave campus with new student loan payments they'll have to fit into their post-graduate budgets. Consolidation provides grads with the ability to combine their student loans into one megaloan, but it comes with drawbacks. Here's what you need to know before deciding to consolidate student loans.

How it works

Loan consolidation is when a borrower takes out a new loan to pay off several smaller student loans. Instead of making multiple payments to multiple lenders, the borrower only has to pay off the new consolidation loan, says Michelle Pezzulli, vice president of operations for Credit Union Student Choice, a student lending service provider in Washington, D.C.

"That new loan will have its own interest rate; it will have its own repayment terms; it will have its own terms and conditions," she says. This can be attractive to borrowers because the consolidation frequently results in longer repayment periods and lower monthly payments.

Consolidating federal student loans

When it comes to consolidation, the types of loans you have matters, but most federal loans, including Stafford, Perkins, Direct Plus and Supplemental loans, can be consolidated with other federal student loans.

"The interest rate on (federal) consolidation loans is an average of the interest rates on the (federal) loans you're consolidating," says Ken O'Connor, director of student advocacy for Fynanz, a New York City firm providing technology for the private student loan market. Even if your rates seem high, t he Department of Education puts a cap on consolidation loan rates at 8.25 percent.

One major advantage of federal consolidation loans is that borrowers don't need a stellar credit score to qualify, they can apply any time (even if their loan is in default) at LoanConsolidation.ed.gov, and they'll always get a fixed interest rate. Regardless of how the market fluctuates, borrowers will never pay more than 8.25 percent on their consolidation loans.

Private consolidation

Private loans can typically only be consolidated with other private loans. And once consolidated, they usually have variable interest rates, O'Connor says. So when you apply counts. Consolidating private student loans when interest rates are low (like now) "could potentially save thousands of dollars." It also means your interest rate can fluctuate higher as the years tick by.

Unlike federal loans, it can be trickier to get your private loans consolidated. Private lenders require borrowers to pass a credit check to get the best rates. That means if your score isn't superhigh, you could wind up paying more if you consolidate. It also means if you're a new grad with little credit history, you might need a co-signer to be eligible. If a co-signer is necessary, O'Connor says borrowers should ask if there's a co-signer release option after a certain period of time.

"With (our student loan program), if the borrower makes 12 months of on-time principal and interest payments, they can request to release the co-signer," he says. "That creates tremendous flexibility, especially for families applying for loans for multiple kids."

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