Interest rates on federal student loans will rise sharply in July. If you haven't consolidated yet, the clock is ticking.

If you haven't yet consolidated your student loans, you'd better get cracking. Rates are on the rise.

The government will reset interest rates for federal Stafford and PLUS loans this summer, and it's expected to bump them up by as much as 1.5 to two percentage points, according to industry experts. This would be the first rate increase in five years — and probably not the last.

Interest rates for Stafford and PLUS loans are reset each July 1, based on the 91-day T-Bill rate determined at its last auction in May. Last year, the T-bill hit a rock-bottom 1.07%. Stafford loans for students in repayment were at 3.37%. After a series of Federal Reserve interest rate hikes since then, however, the T-bill is expected to approach 3% in May. At its latest auction in March, it traded at 2.84%. The Stafford loan rate, were it to be set today, would be 5.14%.

"At this point, it's a no-brainer from a student perspective: You want to consolidate before July 1 in order to lock in the current rates," says Mark Kantrowitz, publisher of FinAid.org, an online financial aid resource owned by Monster.

Crunch the numbers, and you'll see what's at stake. A May 2005 graduate who owes $20,000 in Stafford loans could save more than $4,300 in interest by consolidating them before July 1 vs. consolidating afterward , according to Sallie Mae, the nation's largest educational loan provider. And borrowers already in repayment or parents with PLUS loans could save nearly $5,000.

Sweetening the appeal of consolidation are a number of bills introduced in Congress over the past year that propose switching the fixed consolidation loan rate to a variable rate. Should Congress pass the bill — and it likely will, says Kantrowitz — new fixed-rate consolidation loans would be gone by July 2006.

Here's a quick tutorial on consolidating your loans.

How It Works
If you've got a private loan, you're out of luck. Only federal loans qualify for consolidation, and only those that haven't already been consolidated before. You can, however, combine a consolidation loan with a new loan. (For example, a graduate school loan can be consolidated with previously consolidated college loans.) Among the qualifying loans are subsidized and unsubsidized Stafford loans, Perkins loans, PLUS loans, and other federal educational loans, like Federal Nursing Loans.

When you consolidate your qualifying loans, the lender basically pays them off and gives you a new loan for the total amount. The new interest rate is the weighted average of the loans you are consolidating, rounded up to the nearest one-eighth of a percentage point. You can also consolidate a single loan on its own, using its own rate as the weighted average. This means you will be paying a slightly higher interest rate: For example, if your weighted average is 2.77% — the current rate for Stafford loans during in-school and grace periods — your consolidation rate will be 2.875%. For a weighted average of 3.37% — the rate for Stafford loans in repayment — your consolidation rate will be 3.375%.

In exchange for this slightly higher interest rate, you gain two major benefits. One, you lock in a low fixed interest rate at a time when rates are expected to continue rising for the near future. And two, you're able to extend your repayment term and thus lower your monthly payments. The flipside to this is that you'll pay more in interest over the life of the loan, but you can always prepay the loan with no penalty.

How Lenders Calculate Your Rate

Avoiding the Drawbacks
Right now, the borrowers who are in the most beneficial — but potentially trickiest — position are college seniors graduating this May. They have the opportunity to lock in a rock-bottom 2.875% rate if they consolidate their Stafford loans before July 1. But at the same time, their six-month grace period for starting payments doesn't expire until November or December. And one of the drawbacks of consolidation is that borrowers enter repayment as soon as they consolidate, says FinAid.org's Kantrowitz. "When you consolidate, you lose the remainder of the grace period," he says. For a recent graduate who might still be looking for a job and crashing at cousin Luke's couch, this doesn't seem too appealing.

The good news is that some lenders are willing to give you the best of both worlds. Sallie Mae has announced that this spring's college graduates will be able to lock in the current low rates and still keep their full grace period if they file their application before June 30 — even though the rate in effect when their grace period expires in November or December will already be higher. "(The consolidation rate) is based on the date Sallie Mae receives the application," says Erin Korsvall, a company spokeswoman.

Another potential — and easily avoidable — drawback to consolidation concerns Perkins loan recipients who plan to work in fields like public interest law, teaching or volunteering in such organizations as the Peace Corps. To encourage people to take these typically low-paying jobs, the federal government sometimes offers incentives like forgiving part or all of the borrower's Perkins loans, explains Kalman Chany, author of "Paying for College Without Going Broke." The deal doesn't apply when a Perkins loan is consolidated with other types of loans. The easy solution: Don't consolidate your Perkins loans, says Chany.

Finally, consolidation isn't an option for students who are still in school, which means that college juniors or younger will not be able to lock in the current rates. But parents who have taken out PLUS loans can consolidate, says Chany, since that restriction doesn't apply to PLUS loans. "I'm advising all my clients with PLUS loans to consolidate now," he says. If they take on more PLUS loans in the following years, they can be consolidated separately.

The Repayment Options
Most lenders offer four repayment options on consolidation loans: standard repayment with a 10-year term; extended repayment with a loan term up to 30 years, depending on the loan size; graduated repayment, where payments increase over time; and income-sensitive repayment, which uses the borrower's income level to determine payments.

Another repayment option, offered only with the Direct Consolidation Loan through the Department of Education, is the so-called "income-contingent repayment" program. Unlike private lenders' income-sensitive options, this program pegs your monthly payments to your specific income, family size and debt amount. In addition to that, the government will forgive any remaining balance after 25 years. (This sum, however, is usually taxed as ordinary income. For a list of exceptions, see IRS publication 970.) The plan might sound appealing to those planning to take a low-paid public service job. Its major drawback: Payments increase along with income, and can skyrocket when you get married as your spouse's income becomes part of the equation, says Kantrowitz. Many borrowers end up paying more interest over the life of this type of loan than with the other repayment options.

Generally, private lenders try to steer borrowers into the extended repayment schedule, and often advertise it as their standard repayment option, says FinAid's Kantrowitz. His recommendation: If you can afford it, ask for a 10-year term so that you minimize your interest payments. "You don't want to be repaying your student loans when your children matriculate in college," he says.

Picking a Lender
If all of your student loans are from the same lender, this isn't an issue for you: By law you must consolidate through that lender, says Kantrowitz. The only exception to this rule is if you want to take advantage of the Direct Consolidation Loan's income-contingent repayment option.

Borrowers who carry loans from different lenders can shop around for the best deal. Usually, that means finding a lender that offers the best repayment incentives: Those are typically interest-rate reductions for on-time payments or for enrolling in an automatic payment plan that allows the lender to pull your payments from your bank account. Sallie Mae and Citibank, for example, will reduce your consolidated loan rate by a quarter of a percentage point if you enroll in an automatic payment plan, and will give you an additional one percentage point off when you make 36 payments on time (applies to loans consolidated after December 19, 2003).