Federal consolidation loans combine two or more federal student loans into a single loan, with the interest rate based on the weighted average . This can simplify repayment of your student loans. While these loans can be helpful in some cases, it’s important to understand how interest rates on federal consolidation loans work before jumping in.
How are interest rates on federal consolidation loans set?
The interest rate on a federal direct consolidation loan is not based on your credit score. Rather, the interest rate is based on the weighted average of the current interest rates on the federal loans you’re consolidating, rounded up to the nearest one eighth of a percentage point (multiples of 0.125%).
Federal direct consolidation loans have fixed interest rates based on this average. This means the weighted average interest rate will almost always be between the highest and lowest rates of the loans that are consolidated. While some people might state that consolidating your loans could give you a lower interest rate, with federal direct consolidation this is really not accurate, as the weighted average more or less preserves the cost of the loans.
The only way you would end up paying less over the lifetime of the loan is if your new loan had a shorter repayment term. While this would mean higher monthly payments, your loan would cost you less overall since you’d be paying less interest over its entire lifetime.
How to calculate the weighted average
It’s helpful to take a look at the math to truly understand how the weighted average works. The student loan with the highest loan balance will carry the most weight toward the interest rate on the federal consolidation loan. As the loan balances decrease, their interest rates contribute less weight toward the interest rate on the consolidation loan.
The weighted average multiplies each loan’s interest rate by the loan balance and divides this sum by the total loan balance. In effect, each interest rate is multiplied by the loan’s percentage of the total loan balance.
For example, let’s assume that you have three loans, with loan balances $5,000, $8,000 and $10,000 (a total of $23,000) and interest rates of 4.3%, 4.5% and 6.4%, respectively.
So, to find the weighted average interest rate, follow these steps:
- Step 1: Multiply each loan balance by the loan’s interest rate.
- Loan 1: $5,000 at 4.3% = $215
- Loan 2: $8,000 at 4.5% = $360
- Loan 3: $10,000 at 6.4% = $640
- Step 2: Once you’ve completed step one, add all the values together.
- $215 + $360 + $640 = $1,215
- Step 3: Divide that total by your total loan balance.
- $1,215 / $23,000 = 0.05282
- Step 4: Round up the result to the nearest one eighth of one percent.
- 5.282% rounded up = 5.375%
Should you get a federal direct consolidation loan?
It’s important to weigh the advantages and disadvantages before you decide to get a federal direct consolidation loan.
Here are some reasons you might want a federal consolidation loan:
- You’d prefer to have just one monthly payment. Some people find it easier to plan and stay organized with only one payment to focus on.
- You want to reduce the monthly payments by getting a longer repayment term.
- You want a fixed interest rate instead of a variable one.
- You want to switch loan servicers.
- You have federal loans in the Federal Family Education Loan Program (FFELP), also known as the guaranteed student loan program, and want to move them to the Direct Loan program to qualify for Revised Pay-As-You-Earn Repayment (REPAYE) and/or Public Service Loan Forgiveness.
Here are some reason why you might not want a federal consolidation loan:
- You want to target your highest-rate loan for quicker repayment. When you consolidate your student loans, the loans with high interest rates will be rolled into the weighted average, preventing you from paying down their balances first. You might be able to spend less money in the long term by making extra payments on the loans with the highest interest rates first.
- Federal consolidation does not save money, as it increases the average interest rate by as much as an eighth of a percentage point. Increasing the repayment term also increases the total interest paid over the life of the loan.
- You’re considering going with a private lender to refinance your loans. If you qualify for lower interest rates, this could help you spend less on your repayment. However, going with a private lender means you’ll lose the superior benefits of federal student loans.
Keep in mind refinancing federal student loans means a loss in many benefits – income-driven repayment plans, any federal forgiveness programs, generous deferment options, and more.
- You would lose valuable loan forgiveness options that you have with Federal Perkins loans.
There’s always a trade-off when it comes to making decisions about your student loans. Thoroughly understanding your choices can help you be confident that you’re taking the best route for your financial situation.