Should You Consolidate Student Loans?

NEW YORK (MainStreet)—Virtually no one is excited to deal with student loans, but given the 27 million odd borrowers with outstanding student loans and nearly 12 million Americans taking out student loans every year, millions are looking for ways to ease the burden of ever-accruing student debt.

One possible answer is loan consolidation, which basically means combining your various debts into one bill. Consolidating can simplify your life and reduce your monthly minimum payment, but it often comes with strings attached.

To break down the pros and cons, we spoke to certified financial planner Lauren Lyons Cole and Mark Kantrowitz, creator of FinAid, a comprehensive source of financial aid information and tools.

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Note that our advice will vary greatly depending on whether your loans are federal or private. "Private loans can't really be consolidated," Lyons Cole says. "It's more like refinancing." The two situations are very different, so be very clear on whether you're dealing with federal or private debt.

Federal Loans: Reasons to Consolidate

One of the biggest reasons is to simplify your repayments: When you consolidate, you go from having a bunch of separate loans to one monthly bill. "It's an easier, more organized way of keeping track of what you owe," Lyons Cole says.

Kantrowitz explains that consolidation might easily replace 8 to 12 loans in one fell swoop, because students typically take out a separate loan for each year of school. If you have three types of loans, then you might have a version of each from freshman, sophomore, junior and senior year. That's a lot of separate bills to remember. If you're feeling discombobulated by all the separate little loans, you might find consolidation helpful.

Another reason some people consolidate is to decrease their monthly payments. Lyons Cole tells us that when you consolidate, you restart the length of your loan, which means you can repay your debt over a longer time frame. While that can reduce your monthly minimum payment, don't fool yourself into thinking this is free money; easing your monthly burden now means paying significantly more over the lifetime of your loan, because there's longer for interest to accrue. Still, if you're in a pinch and struggling to pay your monthly minimums, this could help you get over the hump.

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If you're pursuing Public Service Loan Forgiveness (PSLF) and have federal loans that you didn't receive under the Direct Loan Program, consolidation is a great option, Kantrowitz says. Only loans from the William D. Ford Federal Direct Loan Program are eligible for forgiveness. If you have, say, a Perkins Loan, that isn't eligible, but you can consolidate it into a Direct Consolidation Loan. Payments on that new, consolidated loan will count toward the payment requirement for PSLF.

Federal Loans: Reasons Not to Consolidate

Again, there's the double-edged sword of lower monthly minimums in exchange for higher interest over time. Plus, Lyons Cole points out that consolidating can get in the way of repaying your debt as quickly as possible because all your loans get lumped together with one weighted average interest rate.

Kantrowitz agrees.

"If you believe you will be capable of accelerating repayment of your loans, and if you have several interest rates that differ significantly, it may be worthwhile not to consolidate," he said. "For example, if you have a subsidized Stafford Loan at 3.4% and an unsubsidized one at 6.8%, and want to throw extra money against your debt, you'd want to "accelerate repayment of the higher interest rate first."

But if you've consolidated your debt, you can't pick and choose which loan to pay, since now it's all one big loan.

Lyons Cole says to be wary of grace periods and deferments. "Make sure you aren't losing any advantages," she recommends. Consolidation loans don't have grace periods, plus you could lose perks like lender-specific principal or interest rate reductions and cancellation benefits. (For example, Perkins Loans will cancel your debt if your school closes before you can finish your studies, if you serve in the U.S. armed forces in a hostile fire or imminent danger area, or become a full-time police officer. )

"Consolidation is a bit of a headache up front, which may not be worth it for everyone, particularly those who already have all their loans through one lender or don't owe very much," says Lyons Cole.

Private Loans: Reasons to Refinance

A big reason to refinance a private student loan is if your credit score is better now than when you originally got the loan. If so, you might qualify for a lower interest rate, Lyons Cole says.

"You're getting a new loan with a new interest rate based on your current history and credit scores," Kantrowitz explains. Each year you're in school, your credit utilization goes up because you're taking on more debt. That makes your credit score go down and your rates increase. "Right before graduation, your credit score at its lowest," he says. "If you want to reduce your interest rate, wait a few years and repay all your debts on time—not just student loans—show responsible credit behavior and improve your credit score. That will potentially yield a lower rate if you were to refinance."

Also see: Young Student Loan Borrowers Are Bagging the Home Mortgage and Auto Markets

Another big reason to refinance is to get a cosigner off the loan. "More than 90% of students applying for loans have parents as cosigners," Kantrowitz says. "Many parents don't realize that, by cosigning, they're equally on the hook for that debt." If the student is late on a payment, it shows up on her parents' credit history, too. Some lenders will allow the cosigner to be removed from the loan, but only if the student can meet strict criteria proving she's capable of repaying the loan on her own, Kantrowitz says.

If your lender won't simply let your cosigner off the hook, another option is to refinance and get a new loan, without a cosigner—as long as your credit score and history are good. Because you no longer have a cosigner, you'll have to qualify for the loan on your own merits.

Private Loans: Reasons Not to Refinance

If your credit score is worse than your cosigners', your rates will probably go up if refinance in order to get your cosigners off the loan. You might not even qualify for a refinanced loan at all. "Even a 50-point difference in credit score can lead to a difference of several percentage points in your interest rate," Kantrowitz says. "You might not even get approved. I've heard of cases in which a score of 780 or 790 is getting turned down ... which might be because lenders are tightening underwriting criteria as a result of the credit crisis."

As with consolidating federal loans, you should make sure consolidation doesn't get in the way of your plans to target your highest-interest debt first. "Choose the shortest plan where you can still afford the monthly payments," Kantrowitz says. "When you go from a 10-year term to a 20-year term, you're cutting your monthly payment by a third but doubling how much you pay overall, so you're better not doing it unless you really can't afford the higher monthly rate."

Lyons Cole adds that there may be fees involved with refinancing a private loan that make it not worthwhile. So, if you're considering going this route, make sure to read all the fine print and weigh any fees against the potential benefits of lowered interest rates or getting your cosigners off the hook.

Also see: Student Debt Diary: 5 Things I Wish I'd Known Before Borrowing

Some Words of Caution

Kantrowitz warns that you can't consolidate federal and private loans. Although it's theoretically possible to combine your federal and private debt into one loan, when you do so, you're basically nullifying all of the perks of your federal loan. Because federal loans generally have better terms, benefits and forgiveness options, this is not a good idea.

Another tip? Sign up for auto debit if it's offered. When the payments are automatically subtracted from your account, you're less likely to be late, Kantrowitz says, and some lenders will even offer a slight reduction in your interest rate if you sign up for auto debit.

Story by Allison Kade

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