Net Gains: New Savings on Student Loans

June 17, 2008 — -- Recent college graduates and their parents are days away from enjoying what might be one of the last, best opportunities to save money on their student loans.

On July 1, interest rates on some federal student loans will drop by 3 percentage points, allowing certain borrowers no longer in school to lock in a low rate for the life of their loans and potentially save thousands of dollars in interest charges.

They can do this by converting student loans issued before July 1, 2006 into a single consolidation loan that could carry a fixed rate as low as 3.625 percent.

There are a number of rules borrowers need to understand, the first being that waiting until July 1 is key. Act a day too soon, and it will cost them by locking them in at current rates ranging from 6.625 percent to 8.125 percent.

To maximize their savings, however, former students should wait no longer than six months after leaving school. So somebody who just graduated in May has until November to reap the maximum benefit.

Consolidation loans essentially are an opportunity to refinance college debt. The process involves taking one or more student loans and converting them into a single, fixed rate loan.

The process provides the opportunity to lengthen repayment periods in order to lower monthly payments and make it easier to manage multiple loans by combining them into a single monthly payment.

The big incentive, however, has been the opportunity to take a variable rate loan with payments that rise and fall with interest rates and convert it into a fixed-rate loan with payments that remain the same. This was true particularly during periods of falling interest rates.

The consolidation-loan business, however, is in serious decline now as a result of changes in federal student loan rules and the recent turmoil in the credit markets triggered by the subprime loan crisis.

Student lenders such as Sallie Mae that a few years ago aggressively pitched consolidation loans to recent graduates now are pulling out of the market.

This means borrowers will need to take the initiative to save, but the opportunity is still there. The U.S. Department of Education offers consolidation loans to those who cannot find a private lender willing to issue one. To learn more and apply, visit the Federal Direct Consolidation Loans Information Center: loanconsolidation.ed.gov.

This year's graduates may be among the last to realize significant savings from loan consolidation as a result to changes to the federal student-loan program implemented by Congress two years ago. As of July 1, 2006, all federal student loans carry fixed interest rates as opposed to the variable-rate loans that had been issued before then.

With the variable rates changing once a year, an opportunity to lock in a lower rate came during times of falling interest rates. Now with fixed rates only, the incentive to consolidate rates is disappearing.

This year's graduates may be the last big consolidation beneficiaries because variable rate loans were still being issued during their freshman and sophomore years (assuming, of course, they graduated on the four-year plan). They can consolidate their junior and senior year loans as well to ease the management of payments, but they will not save interest charges for those years. In fact, they would see small increase on those rates, so the best thing to do to maximize savings would be to consolidate only pre-July 1, 2006, loans and keep the others as they are.

This year's graduates also are benefiting from this year's turmoil in the credit markets. Rates on variable rate student loans are tied to the 91-day Treasury bill, which dropped sharply over the past year as a result of the subprime loan crisis.

Keep in mind that graduate, medical and law school borrowers who are done with school and parents who took out PLUS Loans also qualify for consolidation and can lock in lower rates on pre-July 1, 2006, loans.

Other factors to keep in mind:

Consolidating a variable-rate loan during the six-month repayment grace period after leaving school or dropping to less than half-time enrollment can cut the locked-in rate by six-tenths of a percentage point.

Borrowers outside the six-month grace period can still consolidate but at a higher rate.

Borrowers currently enrolled in school cannot consolidate.

Depending on the amount of total student loan debt, some borrowers may be able to stretch out their payments to lower their monthly payments. But keep in mind this raises the overall interest paid over the life of the loan. From a cost point of view, a 10-year repayment period is best.

Consolidation loans are available for most federal student loans, including Stafford, PLUS, Perkins and Health Professional Student Loans.

There are more rules to know. To learn more, visit loanconsolidation.ed.gov and FinAid.org, a site that explains the financial aid process and includes a section on consolidation loans.

Reaping the benefits of loan consolidation may be harder this year, but the payoff will be worth it for those who qualify. Be patient.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com