Interest Rate on Consolidation Loan

The interest rate on a consolidation loan is the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest 1/8 of a percent and capped at 8.25%. 

For example, suppose a student has just unsubsidized Stafford Loans originated on or after July 1, 2006. These loans have a fixed interest rate of 6.8%. When they are consolidated by themselves, the consolidation loan will have an interest rate of 6 and 7/8ths of a percent, or 6.875%. So the interest rate increases only slightly.

 

If the borrower has a mix of loans with different interest rates, the weighted average will be somewhere in between. For example, if the borrower has $5,000 of Perkins Loans (at 5.0%) and $10,000 of unsubsidized Stafford Loans (at 6.8%), the weighted average is 

    $5,000 * 5.0% + $10,000 * 6.8%
    ------------------------------ = 6.2%
    $5,000 + $10,000 

This weighted average, 6.2%, is then rounded up to the nearest 1/8th of a percent, yielding a consolidation loan interest rate of 6.25%.

 

Note that the weighted average does not fundamentally alter the underlying cost of the loan. It preserves the cost structure by including each interest rate to the extent that it applies to part of the overall loan balance. For example, the consolidation loan in the previous paragraph says that of the $15,000 consolidation loan balance, $5,000 will be at 5.0% and $10,000 at 6.8%, yielding an equivalent interest rate of 6.2%.

 

If you are consolidating loans with different interest rates, the weighted average interest rate will always be in between. 

Don't be fooled if someone tries to suggest that this will save you money by getting you a lower interest rate. The interest rate may be lower than the highest of your interest rates, but it is also higher than the lowest of your interest rates. More importantly, the amount of interest you pay over the lifetime of the loan will be about the same.

 

(For the mathematically inclined, there is a slight difference due to the different shapes of amortization curves at each interest rate. In the example given above on a 10 year term, $10,000 at 6.8% has a monthly payment of $115.08 and total interest paid of $3,809.66, $5,000 at 5.0% has a monthly payment of $53.03 and total interest paid of $1,364.03. If you add these, you obtain a total monthly payment of $168.11 and a total interest paid of $5,173.69. Using the weighted average, $15,000 at 6.2% has a monthly payment of $168.04 and a total interest paid of $5,165.01. So using a weighted average yields a very small reduction in the monthly payment (in this case, 7 cents) and in the total interest paid ($8.68) due to a kind of triangle law. Of course, when you consolidate the interest rate is rounded up to the nearest 1/8th of a point, so $15,000 at 6.25% has monthly payments of $168.42 and total interest of $5,210.42, yielding a slight increase. So you pay a tiny bit of a premium for consolidation, due to the rounding up of the interest rate.

 

The PLUS loan interest rate loophole can reduce the interest rate on 8.5% fixed rate PLUS loans by 0.25% through consolidation.

 

If you were deferring the interest on an unsubsidized Stafford Loan by capitalizing it, most lenders will add the capitalized interest to principal when you consolidate. (Lenders can capitalize interest at most quarterly, but most capitalize it once when the loans enter repayment or at other loan status changes.) 

SOURCE: www.finaid.org