Should I Consolidate Federal Student Loans and Private Loans?

A question that many student loan borrowers are asking is “Should I consolidate federal and private student loans together?” since they are looking for ways to best organize and manage their debts.

After careful consideration, the answer for many would be “Yes”, but it’s important to consider personal circumstances, current income, career goals and debt elimination strategies.

How can you save money using a new debt elimination strategy?

Achieving a lower interest rate on outstanding student loans is of great importance to any debt elimination strategy. Many students still carry unsubsidized federal loans at 6.8% or Graduate PLUS loans at 7.9% or may have private student loans with even higher rates. Finding a way to simply reduce the rates is important, but apparently hard to achieve.

What is your income?

Federal student loans have income based repayment plans that can reduce payments to a percentage of income. There is a lot of confusion out there about this program, as it’s promoted as “debt relief” when really it’s simply an extension of the loan term from a normal 10-years to 20 or 25 years, allowing for minimum monthly payments to reduce, but potentially costing much more in total interest to repay.

Additionally, at the end of the extended 20+ year term, any debt forgiven is actually a taxable event, so a forgiven loan balance of say $40,000 could add up to an extra tax bill in that future year of $10,000. No one has yet reached that threshold, but there will be some interesting conversations with accountants when this financial milestone is reached years from now. There is no “debt relief” for people with greater income since they would not qualify for a payment reduction, and the federal loan program is unable to reduce the actual interest rate on their applications. If you are a federal loan borrower with high stable income and look forward to increasing that income over the next decade, moving the federal loans into a private consolidation to achieve a lower rate just makes sense.

What is your employment?

Federal student loans may qualify for Public Service Loan Forgiveness, a nice feature for employees of certain government jobs or non-profit organizations when combined with an income based repayment option. This program was designed to allow public service workers to survive on the admittedly limited income that many of these jobs will provide, especially in early years. Since the minimum monthly payment is reduced to only a portion of interest costs, the remaining debt is forgiven after 10 years but is not taxed, unlike the 20+ year taxable loan forgiveness provision.

However, this is an “all or nothing” offer. A Public service employee must maintain their qualified employment and make all required payments during the 10-year term to qualify for forgiveness. If the borrower were to exit their public service job, and perhaps go to the private sector, their federal student loan debt would revert to normal full repayment and end up costing more time and money to repay. If you have low federal student loan debt, high income or private sector employment, Public Service Loan Forgiveness will probably not be helpful for you, and a private student loan consolidation may be more viable.

Fixed rates versus variable rates:

Federal student loans are fixed, creating a predictable amount of interest accrual. However, if those rates are fixed on the higher end it becomes a burdensome amount of interest to repay considering the low interest rate environment we share today. On the other hand, variable rate loans may provide extremely low interest rates today, dramatically reducing current interest costs.

However, by definition, variable rate loans are subject to future change based on the the underlying rate index supporting the loan like LIBOR or in some cases Prime. If these interest rate indices move up in the future, so will the rate on a variable loan. This concern can be managed as follows. First, compare the high fixed rate or variable rate loans currently outstanding to the reduced rate available on a private student loan consolidation. Then consider how much the variable rate would have to increase to equal the high rates of the loans outstanding. Finally, consider forwarding the money saved through interest rate reduction into pre-payments towards the consolidated principal balance. This method can help to accelerate the reduction of the current loan principal amount, reducing future potential interest costs in the event of the rate indices rising.