How do weighted average interest rates work in the context of student loan consolidation?
For students who are struggling to pay off their student loans, consolidating several federal loans into one can provide better rates and help reduce the financial burden of repayment. However, direct consolidation loans do not guarantee the borrowers to benefit from lower rates of interest. Instead, they utilize a weighted average of the interest rates on the new Direct Consolidation Loan's loans, rounded to the closest tenth of a percentage point. This is important for accountants to understand prior to the consolidation process.
What is the weighted average interest rate?
The weighted average interest rate is an average of current student loan interest rates, calculated as the amount owed on each loan. This method is more accurate than averaging interest rates because it takes into account changes in the debt load.
In other words, if you owe $1,000 at a very high interest rate and $10,000 at a very low interest rate, the rates will not be properly weighted since the total is one rate too high.
What Loans Use Weighted Average Interest Rate?
Most loans made by the federal government are subject to the weighted average interest rate. This covers both direct loans and loans through the FFEL program.
There are different types of interest rates used for student loans.
Student loans usually offer two interest rates: fixed or variable. The fixed rate of interest remains the same throughout the life of the loan. Variable interest rates are likely to change based on market conditions. When refinancing, the lender will usually choose different rates based on the interest rate you choose.
How to calculate the weighted average interest rate for a student loan
To calculate the weighted average interest rate for your student loans, multiply the interest rate for each loan by the loan balance, then divide the total loan balance by the amount.
Assume you owe $5,000 on one student loan at 5% and $10,000 on another student loan at 3%. Use the following steps to find the weighted average interest rate you'll qualify for:
Step 1: Multiply the remaining balance of each loan by the appropriate loan interest rate.
$5,000 x 0.05 = $250
$10,000 x 0.03 = $300
Step 2: Add the outputs of these calculations together.
$250 + $300 = $550
Step 3: Divide this calculated amount by your total debt burden.
USD550 / USD15,000 = 0.0366 or 3.66 %
Step 4: Round this percentage to the nearest eighth of a percentage point.
3.66 percent to 3.75 percent
This weighted average is lower than the simple average of the two interest rates, which would be 4%. This is why a weighted average interest rate is used for direct consolidation loans instead of the actual average of all interest rates combined. The weighted average can take into account that the borrower owes twice as much on the loan at a 3 percent lower interest rate.
If you don't feel like doing the math yourself, just find a student loan weighted average interest calculator online.
How direct consolidation loans affect student loan payments
Since direct consolidation loans use a weighted average interest rate, you won't save money if you consolidate your federal student loans. Direct consolidation loans often extend the loan repayment schedule, so you may end up paying much more interest in the long run.
There are other downsides to direct consolidation loans, including the fact that any interest outstanding on your debt becomes part of the original principal balance of the consolidation loan, which means you'll pay interest on a higher balance. You may also lose benefits such as interest rate forgiveness, primary forgiveness benefits, loan cancellation, and any progress toward income-based repayment plans or public service loan forgiveness will be reset.
Also, a direct consolidation loan allows you to modify existing federal student loans without involving a private company. This means that you may qualify for federal student loan benefits such as income-based repayment plans, as well as deferral or forbearance, if you qualify. A direct consolidation loan will also reduce your monthly payment, as your payments will be spread out over a longer schedule.
How to Lower Your Student Loan Interest Rate
Consolidation of your federal student loans through a federal program can offer many advantages, but lower interest rates are not one of them. If you are looking for opportunities to lower your interest rate, here are some things to keep in mind:
Refinance Your Student Loans: Depending on your credit history and income, you may be able to refinance your loans with a private lender at a lower interest rate than you're paying now. If you can't get a lower rate yourself, consider adding a co-signer to your application. However, keep in mind that refinancing federal student loans will result in a loss of access to federal benefits such as loan forgiveness programs, income-driven repayment plans, and more.
Set up automatic payments: If you haven't already, consider setting up automatic payments for your federal student loans. Most federal servicers offer a 0.25 percent discount on your interest rate if you get an autopay plan.
If you decide to stick with your federal student loans, you may not be able to get a lower interest rate, but you can potentially lower your interest charges by doing the following:
- Find forgiveness and repayment assistance programs to help you pay off your balance faster.
- Each month, pay more than the minimal amount due.
- Use the debt snowball method or the avalanche method to tackle low balance debt or high interest debt.
- Pay half of your monthly payment every two weeks, so you have one full monthly payment each year.
- Put your small losses, such as tax refunds, business bonuses, and gifts, toward student loans.
- Get an extra job or a side hustle and invest all that money in your debt.
No matter which approach you take, it is important to take your time to understand all of your options and to choose the path that is best for you.
Bottom Line
When you consolidate federal student loans, you consolidate multiple loans into one loan that only requires you to make one monthly payment. However, the interest rate can be determined using the weighted average interest rate rather than negotiating a new rate. This may mean that your interest rate will not necessarily improve after consolidation.
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