How Debt Consolidation Works

Student Loan Consolidation

Maybe this is a good time to ask for help with those student loans.
Maybe this is a good time to ask for help with those student loans.
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As college tuition costs soar higher than inflation, student debt has risen as well. The Project on Student Debt reports that about two-thirds of students graduating from four-year institutions have debt averaging $19,200 [source: Singletary]. Although student loans can work as a kind of investment in your future, the starting salaries for recent graduates are not keeping up with this rise in debt [source: The Project on Student Debt].

Lowering monthly payments with consolidation proves appealing to cash-strapped graduates. Luckily, restrictions cap interest rates for former students who want to combine their federal student loans through the Direct Consolidation Loan government program. The maximum interest rate for a federal Direct Consolidation Loan is 8.25 percent. [source: Direct Consolidation Loans].

If you have both private and federal student loans, however, you cannot lump them together under a federal consolidation loan. Nor is it a good idea to combine them under a private loan, as your interest rates will most likely rise [source: FinAid]. In addition, you would miss out on important perks that could come in handy for your federal loans, including advantageous repayment, forgiveness and cancellation opportunities [source: FinAid]. Another benefit of federal student loans is that the interest you pay on them is tax deductible.

Assuming that you're still bent on consolidation, you can consolidate your loans with any institution, not just the one where the loan originated. If you can do the research and comparison shop, you will find companies that offer interest rates lower than the federally instituted maximum. Some of these offers stipulate that you must be on time with all of your payments or else your interest rate may rise. That could be harder than you think, especially when you consider the lifespan of your loan.

A bank or a credit card company will not be inclined to offer you a good deal with less than a stellar credit score (such as the 500s), so there are some nasty tactics to look out for if you opt for a finance company. Even alumni associations have been accomplices in the tactics of loan consolidation companies. In exchange for payments, some associations have provided alumni lists to Nelnet, a company specializing in education loans [source: Paley]. Read the next section to learn more about debt management scams and how hidden fees could end up putting you more in debt.