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Updated on Friday, November 13, 2015
If you’re thinking about consolidating your federal student loans, read this post before taking another step.
It could save you a lot of money.
Before we get into the interest rate hack that could save you thousands of dollars and shave months off your debt repayment period, let’s quickly talk about why you would and wouldn’t consider consolidating your federal student loans.
First, consolidating will not get you a better interest rate. You might get a better interest rate if you refinance with a private loan, but that’s a separate topic. When you consolidate, you end up with a weighted average interest rate of all the loans in the consolidation and not just slashing to the lowest possible rate.
The main reason to consolidate is to qualify for income-driven repayment plans. Certain federal student loans disbursed before July 1, 2010 (called FFEL loans) aren’t eligible, but you can make them eligible through consolidation. That can be a big benefit.
You might also consider consolidating if you have variable rate loans and you want to lock in a low fixed rate.
If you’re in one of those two situations, consolidating could make a lot of sense. And there’s a strategy you can use that might save you a lot of money.
To show you how this works, we’re going to talk about a fictitious person named Hailey.
Hailey is single, living in New York, and makes $50,000 per year. She’s also dealing with the following two federal student loans:
- $20,000 balance
- 5.6% interest rate
- $40,000 balance
- 8.5% interest rate
Hailey can afford to put $500 per month towards her student loans right now, which is enough to cover the minimum payments with an extra $75 to spare.
But she’s a little uncertain about her job prospects over the coming years and she’d like to apply for income-driven repayment just in case she needs it.
The problem is that both of her loans are FFEL loans and therefore aren’t eligible for income-driven repayment. Which is why consolidating makes a lot of sense for her.
So how should she do it? Let’s look at the normal way most people would do it, and how she could save herself a lot of money doing it differently.
The Wrong Way to Consolidate
Most people would assume that Hailey should consolidate her two loans into a single loan.
If she did that, she would end up with a single $60,000 loan with a 7.63% interest rate (the interest rate is actually rounded up to the nearest 1/8 percent during consolidation).
But remember, Hailey can afford to put $500 per month towards her student loans right now. Using this debt snowball calculator, and assuming that she pays $500 every month for the life of the loan, here is the result:
- The loan would be paid off in 228 months (19 years exactly).
- She would pay $53,572.99 in interest over the life of the loan.
Luckily for Hailey, there’s a simple way she could save a lot of money without paying any more each month.
The Right Way to Consolidate
You may not know this, but you don’t have to consolidate all of your loans together.
You can actually consolidate a single loan all by itself. And with two loans, you have the option of doing two different consolidations.
If Hailey did this, she would end up with two loans with the same balances and interest rates as before.
However, they would now be federal consolidation loans and therefore eligible for income-driven repayment.
And doing it this way would end up saving Hailey a lot of money.
Because now her extra payments could go towards the loan with the 8.5% interest rate instead of a loan with a 7.63% interest rate, which would have been the case if she had consolidated them together.
And remember, directing extra payments towards your highest interest rate loans is the most efficient way to pay off your debt. So by preserving that higher interest rate, she’s allowed herself to get a better return on every single extra payment she makes.
Assuming she makes the same $500 monthly payment as above and applies the extra payments to the 8.5% loan first, here are the results:
- The loan would be paid off in 218 months.
- She would pay $48,909.94 in interest over the life of the loan.
In other words, with the exact same monthly payment she would save herself $4,663 in interest and be debt-free 10 months sooner.
Are There Downsides to This Strategy?
Obviously this strategy can save you a lot of money, but are there any ways it could potentially backfire?
The short answer is, not really.
It takes a little more work to perform two consolidations instead of one.
And in order to make sure your extra payments are directed correctly, you should send a letter to your servicer letting them know exactly what you want them to do.
But other than that, there’s really nothing to worry about here.
The moral of the story is this: if you’re consolidating your federal student loans, doing separate consolidations for loans with significantly different interest rates could save you thousands of dollars and shave months off your debt repayment period.