The Complete Guide to Federal Student Loan Consolidation

Federal student loan consolidation isn’t easy for many borrowers to navigate.

For some borrowers, federal student loan consolidation is an essential step to getting their student debt eliminated.  For others, federal student loan consolidation would be a major mistake.

Today we will cover it all:

We will also share some tips on getting the most out of the process.

What is Federal Student Loan Consolidation?

At the most basic level, a federal student loan consolidation combines multiple federal loans into a single loan.

However, order to make sense of the multiple rules and fine print of student loan consolidation, it is easier to look at it slightly differently…

Federal consolidation transforms an old federal loan into a new federal loan.  Normally the process involves combining multiple loans into a single new loan, but borrowers do have the option of consolidating a single loan.

The emphasis on the “transformation” is there because the process can either be a good thing or a bad thing.  Some borrowers make a mistake and transform a loan they might like into a lousy loan.  Other borrowers use consolidation wisely and transform a flawed loan into a better federal loan.

What makes a good loan or a bad loan is all about perspective and circumstances.  Perhaps the best way to explain how to utilize this transformation is to give a few examples of what to do and what not to do…

When Should Federal Student Loans be Consolidated?

The classic example of when student loan consolidation is a smart move is Federal Family Education Loan Program (FFELP) loans.  Up until 2010, FFELP loans were from private lenders but they were guaranteed by the federal government.  These loans functioned mostly like federal student loans, but they had a few limitations.

Most notably, FFELP loans are not eligible for Public Service Loan Forgiveness.  However, going through the process of federal student loan consolidation transforms FFELP loans into a federal direct loan.  As federal direct loans, the new loans are eligible for student loan forgiveness.

Another example of a smart use of a consolidation is to consolidate Parent PLUS loans.  One of the big issues with Parent PLUS loans is that they are not eligible for any income-driven repayment plan.  Likewise, they are not eligible for Public Service Loan Forgiveness.  However, by consolidating into a federal direct loan, the Parent PLUS loan can become eligible for the Income-Contingent Repayment Plan and Student Loan Forgiveness.

What makes these two consolidations smart is the fact that a loan with limited federal program eligibility has been transformed into a new loan with better eligibility.

However, this transformation is not always a smart idea…

When Federal Student Loan Consolidation is a Huge Mistake?

The classic example of Federal Student Loan consolidation being a huge mistake is when a borrower combines a Parent PLUS loan with other federal student loans.  As noted in the previous section, a Parent PLUS loan can be consolidated to become eligible for the ICR repayment plan.  However, the consolidated loan is not eligible for preferable repayment plans such as IBR, PAYE, and REPAYE.

If a borrow combines many federal loans into a consolidated loan and includes a Parent PLUS loan, the new combined loan is not eligible for IBR, PAYE or REPAYE.  If a borrower with a $100,000 of various federal loans, all of which are eligible for REPAYE, consolidated the debt with a small Parent PLUS loan, the new large loan would not be eligible for REPAYE.  This mistake could easily cost the borrower many thousands of dollars.  It may be the biggest mistake someone can make with Parent PLUS loans.

Another mistake that borrowers can make with student loan consolidation is to consolidate too late.  For example, a borrower could have 100 out of the 120 required payments in order to qualify for Public Service Loan Forgiveness.  If that borrower consolidates their loans into a new federal direct loan, that new loan would have 0 of the 120 necessary payments.  In this example, the borrower could lose out on over eight years of eligible payments towards forgiveness.

Borrowers who may have made some progress towards public service loan forgiveness with their existing loans would be wise to submit an employer certification form to get a tally on where their loans stand.  A consolidation mistake could have them starting from scratch.

Due to the potentially bad outcomes from consolidation, it is important for borrowers to carefully consider program eligibility and progress before consolidating.  In some cases the consolidation will be an essential step, in others, it would be a huge mistake.

How to Consolidate Federal Student Loans

The actual process of federal direct consolidation is very simple.

The Department of Education will process all of the paperwork electronically.  They estimate that filling out the form takes about 30 minutes.

One potential headache that borrowers should avoid would be third-party student loan consolidation services.  These “companies” perhaps more accurately described as scams advertise a special relationship with the Department of Education.  They claim to help borrowers qualify for Income-Driven Repayment Plans and Student Loan Forgiveness.  In reality, they function as a middle-man who gets paid and adds no value to the service.  In many cases they end up making errors and making the process even more difficult than necessary.

These companies have gotten so bad that at the top of the Department of Education’s Student Loan Consolidation information page, it displays the following:

Department of Education Warning on Consolidation

As long as borrowers stick with the Federal Government Student Loan Consolidation page and are careful to only consolidate when necessary, the process is fairly simple.

Other than deciding which loans to include in the consolidation, borrowers will also need to consider their repayment plan options.  One of the options will allow borrowers to pick the plan with the lowest monthly payments.  However, because multiple plans may have the same low monthly payment, it is best that borrowers research their preferred repayment plan before consolidating.  There are several repayment options that borrowers should consider.

Student Loan Consolidation vs. Refinancing

Student Loan consolidation and refinancing are terms that are often used interchangeably.  In fact, many lenders that refinance student loans call their service a consolidation.

The best way for borrowers to keep track of things it to look at it this way:

Student Loan Consolidation is only done by the federal government and transforms various federal loans into a federal direct loan.  Student loan consolidation does not lower or raise interest rates.  (The Department of Education takes the weighted average of the loans and rounds it to the nearest 1/8th percent.)

Student Loan Refinancing is a process provided by private lenders.  They pay off old loans and in return the borrower agrees to repay the new loan with the new lenders terms.  Usually this is done to get a lower interest rate.  Both federal government loans and private loans are eligible to be refinanced.  Many different companies provide refinancing services, so it is important for borrowers to research their options and understand the consequences of private student loan refinancing.

Other Things to Know

Consolidation may result in two loans instead of one – Federal consolidation typically is presented as a way for borrowers to combine all of their federal student loans into a single loan.  Many borrowers will end up with two separate loans if they consolidate.  This is because the Department of Education keeps the subsidized loans separate from the unsubsidized.

Consolidation is one of the rare opportunities to switch federal servicers – During the student loan consolidation process, borrowers have the option of selecting their preferred loan servicer.

The credit score impact is minimal – When consolidating borrowers may see their credit score move slightly.  For some borrowers it goes up because the old loans show as being paid in full and it is usually better to have one large debt than many small debts.  Others see their score drop, because their student loans were the oldest item on their credit score and average credit age is a factor.  Generally speaking, consolidation really doesn’t move the credit score needle much… the money saved is a much bigger factor.

Hold off on Consolidation if you are about to buy a house – A ton of major changes on a credit report can cause some concern with mortgage companies.  Borrowers who are about to buy a house should discuss consolidation with their mortgage company before starting the process.

The consolidation process can take months – Filling out the form may only take 30 minutes, but the actual process takes months.  In order to consolidate, all of the old loans must be paid off in full, and doing this math takes the Department of Education some time.  After the math has been done, the borrower should receive a letter giving them one last chance to opt out of the consolidation.  Though no action is required from the borrower during this time, the consolidation process is a bit time consuming.

Consolidation can be used as a way out of default – Borrowers who have fallen way behind on their student loans can use consolidation as a quick fix to get out of default.  However, borrowers also have the option to rehabilitate their loan prior to consolidation.  There are a number of factors borrowers should consider when deciding between rehabilitating and consolidating their defaulted loans.

Private loans cannot be included in a federal consolidation – Being able to transform a private student loan into a federal government loan would be great, but it is not an option.

There is no minimum credit score or income requirement – Unlike refinancing with a private company, all federal borrowers are allowed to consolidate their federal loans.  There is not a credit check that borrowers can fail.

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