Should I Consolidate my Student Loans?

When you begin paying on your student loans, you start to look at that mountain of debt a little differently than when they were in deferment.  You begin to ask yourself what shortcuts or smart moves you can make to accomplish this goal as fast as you can.  One of the first ideas that pops into most people’s heads is consolidation.  It’s fairly heavily advertised, so everyone has heard of it, and it is “sold” as a “solution” to your problem.  So is it a solution, or a gimmick?

As with most things in finance, you can find out if it’s a gimmick with some critical thinking and math problems.  In this case, the tool you want to use is called a Weighted Average Interest Calculator.  We will jump to that toward the end of the article, but first there are some nuances you want to consider before signing on the dotted line.

Pros of consolidation:

  • There are fewer payments to be made per month
  • There is a(n unlikely) chance of a lower interest rate

Cons of consolidation:

  • There are usually fees for the recreation of a new loan
  • One large balance makes it harder to gain momentum in the “Debt Snowball”
  • You may actually lose death & disability forgiveness features of the original student debt arrangement
  • It’s possible to actually get a higher interest rate without knowing it
  • You now look at the problem as “solved” and therefore pay minimum payments and stay in debt a long time
  • You may lose income based repayment plans in case you fall on hard times

Now that you have more information about the non-cash features of consolidation, it’s time to explore the mathematical difference you can make.  You will be able to see if you will save any money, if it’s negligible, or if the deal they are offering is actually worse than the deal you already have!

The way we go about analyzing the interest rate of the entire group of loans is called the Weighted Average Interest Rate.  It’s as if we are pretending the group of loans is already one loan, and we determine what the effective rate is.  This is the tool we will use to make your consolidation offer an “apples to apples” comparison.

You can find the Weighted Average Interest Calculator on the Resources page, or you can click on the link here.  Let’s run through a quick scenario that might be deceptive at first glance to demonstrate weighted average interest rates.

Scenario:

  • 4 portions of loans at varying interest rates and balances
    • $2,000 at 9%
    • $1,500 at 8.7%
    • $2,500 at 10.5%
    • $8,000 at 4.5%
  • The Credit Union is offering you a consolidated loan of $14,000.00 at 7.5%

The question becomes, do you take the loan?  If you’re following along with the exercise using the Weighted Average Interest Rate Calculator, you know the answer by now.  Your current portfolio of loans (at first glance) might look like the average interest rate is around 8%.  But when you consider the size of the loans in relation to their interest rate, you find that the Weighted Average Interest Rate is actually 6.7%.  The Credit Union is going to make more money!

The same technique can be used on credit cards, and other forms of debt you might be trying to pay down.  Take a look at this calculator if you are considering consolidation to see if it makes sense.  And if you really are trying to rapidly get out of debt by using the debt snowball method, it’s very likely that you will plow through these smaller loans so quickly that the interest rate doesn’t matter.

Takeaways:

  • The average interest rate isn’t the same as the weighted average interest rate
  • Consolidation often doesn’t save money
  • Consolidation can have negative non-cash affects to repayment options

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