The Benefits of Student Loan Consolidation
By: Jeff Brown

Aside from a fresh diploma, the typical graduating senior leaves college with something not as nice: a mountain of debt.

The Project on Student Debt says about two-thirds of students graduating from four-year institutions carry student loans. Debt loads average more than $20,000 for graduates of public institutions, and closer to $30,000 for those attending private ones. The number of new graduates carrying debt grew by 27%, from 1.1 million in 2004 to 1.4 million in 2008, the latest year surveyed.

Managing the payments is not just a financial burden but a logistical headache, as different types of loans taken out for different amounts can carry different interest rates and due dates.

Fortunately, the federal government has a fee-free program for “consolidating” federal student loans. In addition to replacing multiple payments with just one, it can reduce the monthly payment.

Unlike the typical mortgage refinancing, the student loan consolidation does not reduce interest rates, at least not right away. The rate on the new loan is a weighted average of rates on the old ones, but no higher than 8.25%. That means bigger loans have more influence on the new rate than smaller ones.

What’s the point if the overall rate is no lower? First, the new rate is fixed for the life of the loan, while some of the federal loans eligible for consolidation carry variable rates. Consolidating can thus eliminate the risk of having to pay higher rates later.

A consolidation can also extend the loan term to as long as 30 years, requiring a smaller monthly payment.  Of course, the longer the term, the more interest you pay over the life of the loan.

Fortunately, there are no prepayment penalties. A young college graduate can therefore extend the loan term to reduce monthly payments during the years when money is tight. Then as income rises, the borrower can make extra payments to clear the debt early, eliminating years of interest charges.

Though consolidation can be a good deal, there is an alternative: Use extra money to pay down some loans ahead of schedule, focusing on those with the highest interest rates. Reducing student loan debt will make it easier to qualify for credit cards, auto loans or a mortgage.

But using extra cash to pay down student loans should be balanced against some other financial issues. Many experts, for example, say it’s wise to contribute at least enough to a 401(k) or similar workplace retirement plan to get the maximum matching contribution offered by the employer. Not getting the match is like turning down a raise.

However, for many people, retiring student debt should be a higher priority than saving up for a down payment on a home. Buying a home can be a risky move for people in their 20s, as their housing needs can quickly change if they marry, have children or need to move for a job.

On a purely financial basis, paying down student debt probably makes more sense than putting money into an expensive car. Paying off debt is an investment with a return equal to the loan rate. A car is a depreciating asset, or in other words, a money loser.

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