Consolidation vs. Refinancing Student Loans: Which Is Right for You?

refinancing vs consolidation

When you think about consolidating student loans, you’re probably thinking about Direct Loan Consolidation of federal student loans. But there are actually two different ways to consolidate student loans.

In addition to Direct Loan Consolidation mentioned above, you can also consolidate your student loans by refinancing. Both processes combine multiple loans into a new one, but their similarities mostly stop there.

Direct Loan Consolidation only applies to federal loans and it doesn’t lower your interest rate. Refinancing can combine both federal and private loans, and it often lowers your interest rate or your monthly payments.

Confused yet? Read on to learn about Direct Loan Consolidation and refinancing so you know which one is the better option for you.

Direct Loan Consolidation vs. student loan refinancing

When it comes to consolidating your loans, you have two options: taking out a Direct Consolidation Loan from the government or refinancing student loans through a private lender.

While both approaches combine your loans into one, they go about it in different ways. Here are the three main differences between federal student loan consolidation and private student loan refinancing.

1. Types of loans that are eligible

Direct Loan Consolidation is only available for federal student loans, such as Direct or FFEL Loans. Private student loans do not qualify for federal consolidation.

Refinancing, on the other hand, applies to both private and federal student loans. When you refinance, you combine one, some, or all of your old loans into one new loan with a private lender.

This lender could be a bank, an online lender, or a credit union. Because this new private loan replaces your old ones, you’ll essentially no longer have federal student loans.

2. Impact on your interest rate

Federal loan consolidation doesn’t lower your interest rate, but refinancing with a private lender can. In fact, federal consolidation could slightly raise your interest rate.

When the government issues you a Direct Consolidation Loan, it takes the weighted average interest rate of all your loans and rounds up to the nearest one-eighth of a percent.

Refinancing, however, gives you a new interest rate entirely. You also have the option to choose a fixed rate or variable rate. Depending on your creditworthiness and income, you could qualify for a more competitive rate. A lower interest rate could save you hundreds or thousands of dollars over the years.

3. Repayment term options

When you consolidate your student loans, you’ll choose a new repayment plan. But Direct Loan Consolidation and private loan refinancing come with different options.

If you opt for federal loan consolidation, you could choose the standard 10-year repayment term or get on an income-driven plan. Income-driven repayment plans extend your term to 20 or 25 years, depending on the specific plan. At the end of the repayment term, any remaining balance will be forgiven.

If you refinance with a private lender, you have a few more options for repayment terms. Most lenders offer five, seven, 10, 15, and 20-year repayment plans. A shorter term is ideal if you’re able to handle bigger monthly bills and want to get out of debt as fast as possible. If your goal is to lower your monthly payments, a longer repayment period could help you achieve that.

One thing to note is that private lenders might not be very flexible if you run into economic hardship. Federal income-driven plans adjust your monthly payments based on your income, but most private lenders don’t offer such options.

So if your income is unstable, it might not be wise to refinance federal student loans with a private lender just yet. But if you’re confident about your ability to pay back your loan, refinancing could benefit you overall.

Who should take out a Direct Consolidation Loan?

So when does it make sense to take out a Direct Consolidation Loan? There are two main reasons to consolidate your federal student loans:

  • You want to simplify your monthly payments. Maybe you have lots of different loans and loan servicers and are having trouble keeping track. By consolidating, you’ll make one monthly payment and no longer have to worry about multiple due dates.
  • You need to get on an income-driven plan. Depending on the types of loans you have, you might need to consolidate them to qualify for an income-driven repayment plan.

For instance, Perkins Loans aren’t eligible for PAYE, REPAYE, IBR, or ICR unless you consolidate them first. After consolidating, you can apply for an income-driven plan that extends your loan term and adjusts your monthly bills based on your discretionary income.

When does it make sense to refinance your student loans?

As with federal student loan consolidation, you should consider refinancing with a private lender if you want to simplify your monthly payments. Instead of having to keep track of multiple loan servicers and due dates, refinancing lets you combine it all into just one.

Beyond this, there are some other reasons to apply for refinancing:

  • You have a solid job and are confident you can make your student loan payments each month.
  • You have a strong credit history and will be offered a competitive rate.
  • Your loans have a high interest rate and you want to lower it with a new loan that has a lower interest rate.
  • You want to reduce the amount of time it will take to pay back your student loans, even if it means paying more each month.
  • You want to choose a longer term to lower your monthly payments.
  • You don’t need federal programs such as Income-Based Repayment or Public Service Loan Forgiveness.

Is consolidation or refinancing better for you?

Both consolidation and refinancing have certain benefits and drawbacks. Deciding between the two comes down to your personal situation.

If your main goal is to simplify your federal student loan payments and/or get on an income-driven repayment plan, consolidation could be the right move. But if you have a steady income and good credit score, refinancing could get you better loan terms. Just make sure you understand you’re switching your federal loans into a private one.

There might also be a scenario when both options make sense. You could consolidate your federal loans to simplify your payments. Then, once you improve your creditworthiness, you could apply for refinancing to get a lower interest rate.

As long as you do your research, you’ll be able to choose the solution that works for you.

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