Consolidating Debts, Good or Bad?

Loan PaymentIf you are a younger American, you likely have student debt.  You may have done a great job choosing the right education but it still cost a lot.  Others may have credit card debt or an auto loan.  If you have a mortgage that is a type of debt that I think is a good tool, so we won’t cover it here, but you can apply the same principles from this article to it to see if you should refinance.

Maybe you pay a few hundred dollars a month on your loans which you will banish after 15 years if you keep paying at the current rate(s).  The idea behind consolidating debt is that you could tidy your debt up and hopefully pay less (more important part).

Let’s make up an example.  Bill has three loans each with 10 years left, a car loan of $10,000 at 6%, a student loan of $30,000 at 8%, and a credit card with a balance of $15,000 at 18%.  Bill’s monthly payments are $111, $364, and $270.  You can see that credit card balance is half the student loan amount but since it has such a high interest rate its payment is more than half the amount of the other.  Bill has been paying diligently and has noticed his credit score increase 100 points so he decides to check if he can get better rates.  The best offer he receives is up to $25,000 at a 12% rate over 15 years for a payment of $358.  With this he could consolidate the two smaller loans, however it would be better to just get rid of his credit card debt since that is at a higher rate.  He decides to take $15,000 from the lender and pays off his credit card in full.  Now his payment for went from $270 to $215, but if he pays the $270 he is used to he would finish in under 7 years.

So lower payments are better when the time period is the same.  However, there was another lender who said he could offer even better terms to Bill with a $200 a month plan.  This “better” plan was 14% over 15 years, however Bill saw through this plan since it would add 5 years and $3,600 over the life of the loan.  Unless you really need a lower monthly payment, try to get the best rate.

Fixed versus variable rates

Many lenders offer the option of a variable rate which starts out lower than the fixed rate.  A fixed rate stays the same over the loan period as will your payments.  A variable rate loan will adjust to the interest rate environment.  Read the terms, but it could be that each year your rate gets adjusted.  We are currently in a very low rate environment, so it is likely that rates will increase which would make your payments higher, so beware of variable rate, but do not dismiss them entirely.

Lender perks

Different loans have different conditions, so just like reading your employee handbook, please read your current loan terms as well as any you are considering.  Federal loans have some sweet deals such as your debts can be forgiven after 120 payments (10 years) if you work for a qualified employer.  There is also help for some teachers.  Other loans offer to suspend payments or reduce to interest-only if you become unemployed or give you a discount if you sign up for auto-pay.  Weigh all benefits because it would be a travesty to be a year away from forgiveness only to refinance and have that option taken away.

Fees

Lenders are running a business, so they have to make money somehow.  Some of their profits come from the interest you pay, while the rest comes from fees they collect.

  • Origination fee: A charge taken at the beginning of your loan.  A 2% fee on a $50,000 loan is $1,000 in fees right up front.
  • Late fee: A charge for not making your payment on time.
  • Check fee: Fee charged for paying by check instead of from a bank account.
  • Prepayment penalty: Fees charged for paying your loan off early.  I don’t know if this still is around, but now you know.
  • Stamp tax: A strange .35% tax levied in the state of Florida.  Functions like an origination fee.

Taxes

Student loan interest is deductible, but only up to $2,500.  This is not $2,500 back when you do taxes, but that much reduced from your income, so at a 20% combined rate that could be $500 saved, but this savings is not a good reason to keep your debts outstanding.

Some options for refinancing

I did not order these in a specific way, but I would recommend checking your rates at several if not all the lenders (feel free to find more) so you know your options and are getting the best rates and terms.  I excluded LendingClub because I didn’t find their rates too attractive from a debtor’s point of view.  I also excluded companies that charged an origination fee.

Earnest CommonBond SoFi LendKey
Rates (APR) 1.9-7.25% 3.5-7.74% (student)

4.49-12.99% (personal)

3.5-7.74% (student)

5.95-12.99% (personal)

1.9-6.74%
Amounts Unknown (student)

$2,000-$50,000 (personal)

$1,000-$500,000 (student)

$1,000-$50,000 (personal)

$10,000+ (student)

$5,000-$100,000 (personal)

$7,500-$175,000
Period Up to 20 (student)

1-3 years (personal)

5-20 years 5-20 years 5-20 years

Other than rates what is unique about each lender?

  • Earnest offers merit-based rates and flexibility.
  • CommonBond funds the education of a child in need for each loan it issues.
  • Sofi has unemployment protection and career coaching.
  • LendKey offers low rates through offerings from a community of credit unions and banks.

Conclusion

To answer the post’s title, consolidating debts can be good if you are consolidating to lower rates without giving up amazing benefits.  Debts can be refinanced multiple times and if there are no fees involved to do so, so it would make sense to keep trying to refinance to a lower rate.  I paid off my loans as quickly as possible so I haven’t used any of these services, but I would love to about hear others’ experiences.

2 comments

  1. Big Law Investor says:

    I can vouch for Earnest. I used them to refinance my law school loans. The process is easy and it’s a million times better having the loans serviced by Earnest rather than Sallie Mae or any other of the big four loan servicers. I’m also saving a bunch on the interest.

    If you’re going to aggressively pay off your debt, I think you should self-insure against the changes in interest rate and take the variable option (not that you’re doing this since you’ve paid off your loans, but I mean people generally). Variable rates are often about 1% less than fixed rates and it’s clear that the Fed isn’t moving to raise them quickly. Since you’re aggressively paying down the debt, you’ll save the 1% difference in year 1. In year 2 maybe rates are the same as they would have been on the fixed plan (so you’re no better or worse off). In year 3, rates would have to rise substantially to make it a bad deal given that the overall balance of your student loans is now considerably lower.

    • Dr.J @ MedSchool Financial says:

      Glad to hear that the law school refi is working out well. The goal is finding favorable rates and with intentional focus to eliminate these debts and agree that professional education loans as they continue to increase , it is an important point to consider.

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