What is a Federal Consolidation Loan?

By | 2017-10-24T23:17:54+00:00 October 24th, 2017|Student Loans|0 Comments

Last week, I talked about student loan refinancing, so when I was thinking about a new topic, it was only natural that I chose federal consolidation loans this week. There’s the logic. Here’s the article.

Oh yeah, before I start, I apologize for the boring “What Is…” articles. We want to write more interesting content, but we’re trying to cover a few basics first. Also, it’s tough to find time to write, so tonight, I’m settling on a nice descriptive, informative article. Enjoy!

A Federal consolidation loan is a type of student loan offered by the Federal government to students with pre-existing federal loans. It’s part of the Direct Loan Consolidation Program, so it’s formally known as a Direct Consolidation Loan.

The point of a Federal consolidation loan is to replace your pre-existing student loans (they must be federal loans) with just one loan, hence the term consolidation. When you consolidate, you’re left with one student loan (and only one monthly payment) and a new set of terms and conditions.

What sort of terms and conditions can you expect?

You have your pick of the federal litter when it comes to new repayment plans. You can opt for the standard ten-year repayment plan, a.k.a. 120 monthly payments, or you can go all the way and extend your repayment term to 30 years. You can also pick an income-driven repayment plan (IBR, ICR, PAYE, or REPAYE) which would cap payments at 10 to 20 percent of your income for a set time.

You also get one, new interest rate. When you consolidate, your new interest rate is formulated as a weighted average of your previous interest rates. For example, if you have two $5,000 loans at 6 percent interest and two $2,000 loans at 4 percent interest, then your weighted rate is 5.43 percent. Since it’s weighted, the larger loans have a greater influence on your final rate which is why it’s much closer to 6 percent.

So voila! You have just one loan, one monthly payment, one interest rate, and one loan term. So, what’s the actual point of a federal consolidation loan? For starters, you have a simplified loan experience, so there aren’t multiple payments or loans to handle anymore. But there are bigger questions here.

Does it Save Money?

The answer is two-fold: yes, and no! That sounds great because yes and no directly contradict themselves. Don’t worry, I’ll explain.

Let’s start with no. When you consolidate your loans, you’ll remember that you receive a new, weighted interest rate. Since this is the policy, you don’t actually have a chance at saving money by the end of the repayment term. There is no actual reduction in interest, so interest accrues at just about the same rate as before.

Next up is the yes. It can be said that you can save money through a federal consolidation loan – sort of. You have the option to extend your repayment schedule up to 30 years. By doing so, you are effectively reducing your monthly payment significantly. With that being said, applying for federal consolidation can be a useful tool to save money in the short-term.

So, if you’re struggling to make payments, then you can extend out the payment schedule and reduce your monthly obligation. However, while you’re saving money in the short-term, extending your payment schedule up to 30 years will cost you more over the life of your loans. Interest will have longer to accrue on the balance.

I just need to reiterate. While I said yes and no, keep in mind that you’re not going to save money on a federal consolidation loan no matter what by the end of repayment.

Here’s an example. Let’s say you have 6 years left on repayment on a few loans, and you decide to consolidate. You pick the 10-year repayment schedule, the shortest option. You just tacked on an extra 4 years to your overall repayment. With no drop in the interest rate, you’re making payments for those additional years at the same capitalization rate, a move that will always cost you more.

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