Giving Your Student Loans a Record-Low Fixed Rate

Rates on student loans are primed to hit their lowest level in history, even as interest rates on other types of consumer debt are rising.

That’s got many experts crowing about consolidation, a process that allows borrowers to lock in today’s historically low rates for the life of the loan.

What is loan consolidation and how might it help or hurt today’s borrowers? Here are a few answers.

Question: Why are student loan rates dropping?

Answer: Because interest rates on short-term Treasury bills are at historically low rates, and those rates affect the rates on both major types of federally guaranteed student loans: Stafford loans, which are made to students, and Parents Loans for Undergraduate Students, or PLUS loans.

Once a year, the Department of Education adjusts the loan rates based on the prices set at the last 91-day Treasury bill auction in May, which took place Monday. This rate becomes the “index” rate for all unconsolidated student loans. This year the index rate dropped to 1.07%.

The Stafford loan rate is set by adding a “margin” of 2.3% to the index rate. The PLUS loan rate is set by adding a 3.1% margin to the index.

So that means Stafford loan rates will drop to 3.37%; PLUS loan rates will drop to 4.17%. These new rates apply to all student loans -- those issued years ago, as well as ones issued for the coming school year.

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Q: What’s consolidation?

A: It’s a process in which students can refinance all of their student loans into one new loan. In the process, the student debt converts from a variable-rate loan that adjusts once annually into a fixed-rate debt.

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Q: Can you consolidate if you have only one loan, just to get the fixed rate?

A: Yes.

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Q: How is the rate on a consolidation loan set?

A: It’s based on the weighted average rate of all the loans being consolidated, rounded up to the next eighth of a percentage point. In other words, if the weighted average cost of the student’s debts is 3.45%, the rate on the consolidation loan would be rounded up to 3.5%.

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Q: Are there any fees or charges to get the loan?

A: No. The only cost is in the rounding up of the interest rate.

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Q: How much does the rounding up cost you in dollars and cents?

A: That depends on the size of the loan and the interest rate. But, to give an idea, consider a borrower with two $10,000 PLUS loans, which would be at a 4.17% rate in July. If these loans are consolidated, the borrower’s loan rate will be rounded up an eighth of a percentage point to 4.25%. That would boost the monthly payment on the loans by 77 cents a month, or $92.40 over the 10-year life of the loan.

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Q: So why pay that extra money?

A: Because you’ll be able to lock in that 4.25% rate. The Federal Reserve is signaling an increase in interest rates, and many economists expect that loan rates will be higher at this time next year.

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Q: So why wouldn’t someone consolidate?

A: They may want to take their chances that interest rates will continue to fall. That bet would have paid off big five years ago, when the student loan rate was 8.19%.

One detriment to consolidating is that once you’ve consolidated, your loan rate is set. If interest rates fall, you don’t get to take advantage of the lower rate. Unlike a mortgage, you can’t simply refinance a student loan every time interest rates drop. Once you’ve locked in a rate, it’s locked for as long as you hold that student loan.

Market experts do expect rates to rise over the coming year. Although it’s impossible to say how much they might rise, there have been numerous points in history when loan rates swung by 2 or 3 percentage points in just a single year. Rates on Stafford loans cannot rise above 8.25%; rates on PLUS loans are capped at a maximum of 9%. But there are no other restrictions on how much student loan rates can rise in any given year.

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Q: Are there any other detriments to consolidating?

A: Experts advise against consolidating Perkins loans, which are federally subsidized loans for needy students, because these loans offer special benefits that are lost in consolidation. Among other things, some Perkins debt can be forgiven for those who go into the military or other kinds of public service. The government also generally pays the interest on Perkins loans that are deferred. None of those benefits will survive a consolidation.

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Q: Can I consolidate my Stafford loans but not the Perkins loans?

A: Yes. You can pick and choose the loans you want to put into a consolidation loan.

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Q: What if I want to wait and see where interest rates are heading? Is there a deadline for consolidating my loans at the new rate?

A: You can wait until June 2005. And that may be a wise strategy. Just put a note in your calendar to check the prognosis for student loan rates at the end of May 2005. (That’s when the index comes out.) Your lender will know whether rates will be going up, remain the same or drop yet again. You can decide then whether to consolidate or leave the loan alone. But, at that point, you’ll have to hurry because you’ll have only a month before the new rates go into effect. Once it does, you forever lose the ability to lock in today’s low rates.

There’s one other caveat. Congress is weighing a change to student loan rules that would eliminate fixed-rate consolidation loans. If this change passes, there will be no way to lock in a fixed rate in the future. This bill is unlikely to pass this year, but experts think it might next year. Keep an eye on the news.

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Q: Is there any argument to consolidate in a hurry?

A: There is for recent graduates. That’s because those who consolidate their loans when they’re in a grace period -- a payment hiatus that lasts six months after graduation -- get an additional break on the interest rate. Instead of paying 3.37%, their rate would be set at 2.77%.

If they consolidate during that grace period, they’ll lock in the lower rate -- or, rather, a rounded-up version on the lower rate -- for the life of the loan.

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Q: Is there any reason not to consolidate during a grace period?

A: Once consolidated, loans go into repayment. So those who consolidate early in a graduation grace period will face payments sooner than they would have otherwise.

It’s wise for borrowers in grace periods to wait to consolidate until a few months before the end of that period, said Martha Holler, a spokeswoman for Sallie Mae. That still qualifies them for the “in-deferment” rate break without forcing them to start making payments too soon.

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Q: Does consolidation allow you to stretch out the payments?

A: Yes, but only if you are consolidating more than $7,500 in student debt. The maximum duration of larger loans can vary from 12 years to 30, based on the total loan balance. The bigger the loan, the longer you can have to repay it.

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Q: What’s the point of stretching out the payments?

A: That lowers your monthly cost and may allow you to pay off other, higher-cost debt. The General Accounting Office reports that most students graduate with thousands of dollars in debt on credit cards, for instance. It makes a lot of sense to pay off a 14% credit card loan before paying off a student loan that costs only about 3%.

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Q: But won’t I pay more interest if I lengthen the duration of the loan?

A: Yes, but your monthly payments also will drop. If the monthly savings allows you to do something smart -- like pay off high-cost debt or participate in lucrative employee savings plans -- it can be a wise trade off.

To illustrate, consider a borrower with $50,000 in student loans, who consolidated while in a grace period, getting the 2.875% rate. (That’s the 2.77% in-deferment rate rounded up to the next eighth of a percentage point.) He decides to stretch out the loan repayment because he wants to participate in his employer’s 401(k) plan and otherwise wouldn’t have the cash to do it.

If he stretches his student loan payments out over 25 years instead of 10, his monthly cost drops to $233.87 versus $479.92. But because he’s paying on the loan 15 years longer, the total cost to pay off the loan soars to $70,160 from $57,591.

Meanwhile, he socks the $246 monthly savings in the 401(k), where his employer offers a 25% matching contribution -- a common employee benefit.

If he earns a modest 6% on his 401(k) investments over time, he’ll end up more than $200,000 ahead at the end of the 25 years.

How? He pays $12,569 more in student loan interest over time, but his $246 monthly savings generates a $61.50 company match, allowing him to sock away roughly $307 each month. He also earns twice as much in tax-free returns than he paid on his student debt. Over the 25-year period, his 401(k) account grows to $213,096.

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Q: I’m being pitched by dozens of loan companies. Does it matter who I choose to consolidate my loan with?

A: Yes. Although the interest rate on the loan is determined by government rules, some lenders offer valuable deals to borrowers who pay promptly or who set up automatic payment plans.

For instance, All Student Loan in Los Angeles will cut student loan rates by 1.125% for those who pay on time for at least 36 months, said Chip Chapman, the company’s president and chief executive.

College Loan Corp. of San Diego offers a 0.25% interest rate cut for those who choose an automatic debit plan that takes payments directly out of the borrower’s checking account.

It also sometimes offers a cash rebate for those who have made at least six on-time payments, said Mark Brenner, College Loan’s executive vice president. The one-time rebate, available only to those with $30,000 or more in consolidated debt, amounts to 1% of the principal amount up to $100,000.

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For past columns, visit latimes.com/kristof.