Consolidate Your Student Loans Now!

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With interest rates near 40-year lows, now's the time to lock in and reduce your monthly payments.

STEVEN SCHELL, a 31-year-old attorney from New York, is almost as obsessed with interest rates as Federal Reserve Chairman Alan Greenspan. He may not have the weight of the U.S. economy riding on his shoulders — but he does have $40,000 in Stafford loans. Needless to say, that's quite a burden.

To help ease the pain, in 2003 Schell consolidated his loans. Wise move. That saved Schell more than $400 a month (provided he only pays off the minimum on his new 30-year loan).

Every year thousands of consumers like Mr. Schell take advantage of Federal Consolidation Loans in order to lock in the prevailing interest rate and lower their monthly payments by extending the payback period. Consumers with student debt who haven't yet taken advantage of this program — sorry folks, you can only do it once — have the opportunity to do so now and lock in the lowest rates in nearly 40 years. The government resets its lending rate anually in July.

If you haven't consolidated your student loans, here's a quick tutorial on how to go about doing so.

Consolidation 101
Federal Consolidation Loans were created as a debt-management tool to help consumers lower their monthly payments. As we mentioned above, a borrower can combine all of his federal student debt into one payment and lock in the prevailing rate for the lifetime of the loan. Otherwise, the rate will rise and fall with variable interest rates every year. When you consolidate, the original loans are paid back in full and a new loan with new terms is originated for the combined balance. And consolidation is easy and free. All you need to do is ask your loan servicer for an application. If your loan is through Sallie Mae, you can even apply online on their Web site.

You should know, however, that when you consolidate, your repayment period is elongated from the previous 10-year term to a 30-year term. This means the total amount of interest you owe rises dramatically. So if you had, say, a $50,000 loan, you'll owe a total of $86,558 rather than the original amount of $66,582 on a 10-year Stafford loan. The good news is that there's no prepayment penalty should you decide to attack the principal at a faster pace.

Of course, if you're struggling financially and consolidation doesn't appeal to you, you could also apply for a deferment. Deferments are granted if you meet certain eligibility requirements, such as economic hardship or unemployment, and typically last for about a year.

Rock-Bottom Rates
Whether you choose to consolidate or not, there are other ways to knock that interest rate down even lower, says Martha Holler, a spokeswoman for Sallie Mae. If you sign up for Sallie Mae's automatic debit-payment plan, called Direct Repay, the rate drops 0.25%. And after 36 months of on-time payments, the interest rate falls an additional 1% if you have at least $10,000 worth of loans.

Better yet, this interest may be tax deductible. The IRS allows you to fully deduct up to $2,500 in interest payments per year if your adjusted gross income is below $100,00 for married couples filing jointly and $50,000 for singles. The amount you can deduct starts to phase out if your income exceeds those limits, and isn't available at all for those with incomes above $130,000 and $65,000.

Private Loans
What about the private loans you had to take out to cover the rest of your education expenses? Unfortunately, they don't qualify for this program. Consolidation is only for subsidized and unsubsidized Stafford loans, Plus loans, Perkins loans and loans issued under other federal education programs. Just for convenience, some lenders, such as Sallie Mae, will add up the total cost of your federal and private loans and allow you to pay with one check. But, technically, they still remain separate financial commitments.

We should also warn you that there are plenty of banks out there that will try to convince you to consolidate all of your debt — both private and federal loans — into one new loan. But it's doubtful that you'll get a better rate. Most banks charge the prime rate plus some additional amount. You'll also be giving up your rights to the other benefits federal government loans offer, such as the rate-reduction rewards for on-time payments and direct deposit, says Sallie Mae's Holler.