Never consolidate your federal loans. Seriously.

April 11, 2017

by — Posted in College Finance, Gaming FICO, Student Loans

U.S. federal student loan programs allow borrowers to consolidate their individual term and rate-based loans (with varying interest rates and terms) into one giant student loan with a blended interest rate (made up of constituent loan amounts and rates). Many borrowers find this kind of change fairly benign and/or easier to keep track of, but doing so may come at a heavy cost. While there is no significant upside to federal student debt consolidation, there are several gotchas of which to be wary:

  1. Your effective interest rate will always increase by up to .125%.

    The federal government exchanges all your prior loans for​ a single ​consolidated loan. To determine the new rate, they take a weighted average of prior loan balances and rates under your prior loans. Then, they round up to the nearest one-eighth of 1 percent.

  2. While I consider Public Student Loan Forgiveness programs a complete sham (see Betsy Devos for more info there), many people working for the government or certain non-profits do occasionally benefit from them. These jobs typically come with low salaries and/or funding, so loan forgiveness is a nice enticement to fill these positions. PSLF forgives federal student loans for borrowers employed full time in an eligible position once they’ve made 120 eligible on time payments. But guess what consolidating your loans does? That’s right. It might make you ineligible to ever have your loans forgiven. And if you use a direct consolidation loan (the only eligible type),
    your payment clock is reset to 0.

    I think loan forgiveness is fundamentally a bad deal for students. 120 on time payments = 10 years of on time payments in a row. That’s literally the standard repayment time for federal loans. So the only way you can even benefit from this is if you take a job that ensures you’ll be poor for at least 10 years (so you can go on IBR and increase your repayment period). What a great opportunity, right? Then, hypothetically, after making 5 years of on time payments, you decide to take control of your finances and consolidate. But now you have to make another 120 on time payments to ever qualify for forgiveness. So please just don’t.

  3. Guess what refinancing does for Teacher Loan forgiveness programs. Oh yeah. Same thing. Kiss all your money goodbye.
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  5. Making on time payments to 17 small loans is considerably better for your credit score than making payments to one big loan.

    A higher credit score will help you get better rates on loans and credit in the future. So why not do nothing and let your FICO score improve even more? Having a lot of student loan accounts means you don’t have a “thin file” and improves your odds of being granted credit as well. I’ll write more about gaming FICO in the future. For now, jus tremember that having more accounts and payments on record is always a good thing for you.

  6. When you consolidate, you lose the ability to direct your loan payments to higher rate debts.

    You want to have a bunch of small loans because it increases your flexibility to pay higher interest rate debt off first (or refinance it privately — parent plus loans are the worst. Bad interest rates. Bad terms. Etc). You lose all flexibility to control your payments with a consolidation loan and, in some cases, you won’t even be able to refinance privately later on.

The only time you should ever even consider a consolidation loan is to get all your loans out of extended default. I don’t see any other case where it’s in your long term interest to consolidate your federal loans. Private loans should always be refinanced whenever possible, however. More on that later.

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