Consolidating federal loans less appealing with fixed rates

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Just a few years ago, student borrowers couldn't check their mailboxes without wading through letters from companies offering to consolidate their loans.

These days, those offers have slowed to a trickle, if they arrive at all.

Consolidation -- until recently the recommended course of action for almost all loan holders -- is now distinctly less appealing for borrowers and lenders.

"It's not something that we advocate as a way to solve problems," said Tom Lustig, vice president of PNC's Education Loan Center. "It's really for someone who has that specific need."

Today, the primary reason borrowers should consolidate is if they can't afford their monthly payments and need to lower them by stretching out their loans over a longer period, said Mr. Lustig.

Some borrowers with several different loans -- possibly from different companies -- also might wish to consolidate to make just one payment a month, he said.

Loan consolidation was introduced in the 1980s for the same reasons that it's used now: To allow borrowers to stretch their payments over a longer period or to combine multiple loans into one.

Loans from the federal government used to come with variable interest rates that would adjust once a year.

As interest rates dropped from more than 8 percent to below 3 percent, borrowers consolidated as a tool to refinance the loan and lock it in at a lower interest rate.

In 2005, for example, when interest rates on federal Stafford loans dropped to a low of 2.77 percent for some borrowers, more than 1 million people consolidated.

"Especially three to four years ago, when the rates were 2 to 3 percent, people were jumping on to getting a fixed-rate federal loan," said Mr. Lustig. "Those days are over."

In 2006, the federal government switched to an interest rate fixed at 6.8 percent for Stafford loans. (That rate will go down over the next few years for subsidized loans because of the College Cost Reduction and Access Act of 2007, but will still be a fixed rate.) Some lenders offer discounts.

Because the interest rate isn't adjusting every year, borrowers no longer have the option to lock in their loan at a different rate -- eliminating one of the main reasons to consolidate.

Furthermore, the college cost act reduced the profits that loan companies make from loan consolidation, making them less likely to push it aggressively among borrowers.

"I'm not sure it was a big money-maker before, but at least it was something that made sense for the lenders to offer," said Mr. Lustig. "Now, it's much less attractive."

To ensure that there's still a financial benefit, lenders might raise the minimum amount required, said Robert Shireman, executive director of the Project on Student Debt, a program of the nonprofit Institute for College Access and Success, based in Berkeley, Calif. Others might just scale back their lending activities.

"We will see less aggressive marketing," said Mr. Shireman. "Some of these companies have focused almost exclusively on consolidation loans rather than making loans, and we'll see them shrink in their activities."

Those who do want to consolidate should be aware of the costs, said Mr. Lustig.

Borrowers who have $23,000 in Stafford loans -- the maximum for an undergraduate -- at 6.8 percent would pay $264.68 per month if they didn't consolidate and paid the loan off on a 10-year schedule.

A loan holder who couldn't afford those payments could consolidate the loan out to a 20-year-repayment term. Stretching out the loan would reduce the payments to $175.57 per month.

Under the second scenario, however, the borrower would pay more than twice as much interest over the life of the loan ($19,135.83 vs. $8,762.42).

"You can say, 'Wow, my payment is so much lower,' but you end up paying off so much more," said Mr. Lustig.

Most people who consolidate their loans choose the maximum payoff term, which varies up to 30 years depending on the amount of the loan, said Mr. Lustig. So unless they pay the loan off early, they end up paying substantially more in interest.

There is also a financial disincentive in the loan interest rate. To determine the interest rate for consolidated loans, the lender will take a weighted average of the interest rates of the loans being consolidated and will then round up to the nearest one-eighth of a percent.

So if a borrower chooses to consolidate two loans, both at a 6.8 percent interest rate, the interest rate on the consolidated loan would actually be 6.875 percent.

Borrowers should also be aware that they may lose some loan benefits that came along with the original loan when they consolidate, though they might gain new benefits from the consolidated loan. Any new benefits should be in the loan contract, said Mr. Shireman, or else they can be taken away or altered in the future.

Unlike refinancing a home mortgage, there are no "closing costs" associated with student loan consolidation. "If a lender charges you a fee before you can consolidate, keep shopping," said Mr. Shireman.

Mr. Shireman also said he strongly discourages borrowers from consolidating federal loans in the same package with private loans, because they can lose some of the consumer protections that are part of federal loans.

In addition, student loans usually can be consolidated only once, said Mr. Shireman, though re-consolidation is possible if a borrower has new loans that weren't part of the original consolidation or wants to take advantage of the new public service loan forgiveness program.

While some students have benefited from lower rates through consolidation, others found themselves inescapably locked in to a higher rate when rates fell.

Stephanie Shea of Wilkinsburg, who consolidated her federal student loans at 7.5 percent in 1999, said it is "disheartening" that she can't refinance them to take advantage of a lower rate.

"You can refinance your house and credit card," she said.

For those who can't afford their monthly payments, there are a few alternatives to consolidation.

If borrowers have more than $25,000 in Stafford loans and first borrowed money on or after Oct. 7, 1998, they can extend their repayment term to 25 years without having to consolidate and pay the higher interest rate.

In some federal loan programs, borrowers currently can make repayments tied to their monthly incomes. Under income-sensitive repayment, the amount varies from year to year as a percentage of the borrower's gross income. That option is used by less than 1 percent of PNC's loan customers, said Mr. Lustig, because the total costs are usually higher and borrowers potentially can face a balloon payment as their loans come due.

As of July 1, 2009, borrowers will have a better option to factor their income into payment amounts for federal loans, particularly federal Stafford loans.

The College Cost Reduction and Access Act of 2007 provides for an income-based repayment option that takes income and size of household into account in coming up with an affordable monthly payment.

If the federal loan still isn't paid off in 25 years (or 10 years for those working in some public service jobs), then the loan is forgiven and taxed as income.

Mark Kantrowitz, the Cranberry-based publisher of, a student aid information Web site, said the new option will typically be a better choice than the existing income-sensitive or income-contingent options available on some federal loans.

"To the extent that people have been consolidating because their income is low, they'll now have IBR," said Mr. Shireman.

Even though there are other options, many borrowers think immediately of consolidation because it was so highly recommended several years ago.

"The student consumer is much more aware because of the frenzy of consolidation activity," said Mr. Lustig. "Some of that might be in their minds. Once they examine their options, talk to a counselor and talk to their school, hopefully there's enough information. I wouldn't be surprised if some people think [loan consolidation] is a quick fix to a problem."

Anya Sostek can be reached at or 412-263-1308.


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