With total U.S. student loan debt surpassing the 1.4 trillion mark, borrowers have become even more reliant on debt to finance their education. And with plans available from both public and private lenders, loans usually end up spread across multiple institutions.
To combat this issue, student loan consolidation allows you turn multiple small loans into one large loan financed by a single a lender. When applied, the new lender pays off all of your student loan debt and refinances the debt into a single loan.
Previously, we outlined how student loan refinancing can help you obtain a lower interest rate.
But, can consolidation actually increase your credit score as well?
What Is A Student Loan Servicer And Why Does It Matter?
Public student loans are offered through the U.S. Department of Education. Its Federal Student Loan Portfolio is comprised of billions of dollars’ of Federal Direct Loans, Family Federal Education Loans (FFEL) and Perkins Loans. For more information on how public student loans work, check out our article on Federal Student Loan Interest Rates.
When a payment is made each month, your funds are directed to a federal student loan servicer. The debt collector is assigned by the U.S. Department of Education and is used to make collections on its behalf. Because many student loan borrowers make one large payment per month, they’re often surprised to find out the entire sum is actually spread across multiple lenders. For example, if you take out a student loan at the beginning of each academic year, you can have as many as four separate lenders listed in your credit report.
How Does Student Loan Consolidation Help Your Credit Score?
When you consolidate several active loans into a single credit account, it reduces the noise in your credit report, making you look more reliable in the eyes of lenders. More importantly, credit scoring models – like FICO, Experian or TransUnion – take into account your active credit accounts when quantifying your credit score.
So while consolidating your student loans won’t actually remove the accounts from your credit report – instead they’ll be labelled as ‘paid’ – the process does shrink the number of active accounts which reduces your overall credit risk. Now, before you get too excited, the bump in your credit score will only be marginal. Other variables like your payment history, credit utilization and debt-to-income ratio hold much more weight in most scoring models. However, every point counts. And student loan consolidation is a way move your credit score in a positive direction.
The practice also offers less downside risk.
If you miss a student loan payment – in the previous scenario – you end up defaulting on multiple small loans issued by multiple lenders. In your credit report, each account will be labelled as past due. This is extremely damaging to your credit score because scoring models will portray the result as several delinquencies instead of just one.
Now imagine you’ve consolidated your student loan debt.
If you miss a payment, the ‘past due’ label will still apply. However, now, the delinquency only affects a single account. Your credit score will take less of a hit because the late payment is confined to one account.
What Are The Pros And Cons Of Student Loan Consolidation?
Before deciding whether student loan consolidation is right for you, remember that consolidation requires you to convert your public student loan into a private student loan. Because of this, you need to consider multiple factors before making your final decision.
Pros of student loan consolidation:
- Lower Interest Rates: Many private lenders offer refinancing options that can shave 0.5% to 1% off your interest rate. As an example, if you have $30,000 in student loan debt and plan to repay the proceeds over 10 years, you will save $1,735.32 in total interest by reducing your interest rate from 5% to 4%.
- Variable Interest Rate Options: Public student loan interest rates are fixed, so they don’t fluctuate with U.S. Treasury yields or central bank policy. With private student loans, you can opt for a variable interest rate structure. Thus, if rates decline, the interest rate on your consolidated loan will decline as well.
- Co-Signer Options Are Available: With private student loans, a co-signer can help you obtain more favorable loan terms and a lower interest rate. With public student loans, you usually don’t have this option.
Cons of student loan consolidation:
- Foregoing Financial Assistance: With public student loans, if you demonstrate significant financial need, the government can pay a portion of the interest on your loan while you’re in school and after you graduate.
- Forgoing Delayed Repayment: With public student loans, you don’t need to repay the loan proceeds until after you graduate or your enrollment status dips to part-time. Conversely, private student loans can require repayment while you’re still in school.
- Foregoing Loan Forgiveness: Public student loans offer loan forgiveness to borrowers who qualify. Private student loans don’t have this option.
While student loan consolidation can provide a slight increase in your credit score, you need to weigh multiple factors before making the switch. The benefit of the tactic is shrinking a large number of small loans into a single debt account. By doing so, you decrease the active number of credit accounts in your credit report, which helps lower your risk in the eyes of lenders. After consolidation, the negative effect of a missed payment also decreases in magnitude. On the flip side, switching from a public to a private student loan requires you to forfeit many of the benefits embedded in public student loans. These include financial assistance, delayed repayment and loan forgiveness. Thus, before you make your final decision, we recommend you weigh the pros and cons and choose the option that works best for you.