Interest rate

How Does Student Loan Consolidation Work?

Nowadays, the cost of higher education is getting more and more expensive. Some families may not be able to afford further education for their son or daughter. Getting a student loan will help.

There are 2 broad categories of student loans available. Government student loans and private student loans

Government or federal student loans are funded and administered by the US Department Of Education. It is classified under Federal Student Loans Aid Program. They have very few requirements other than you are studying in a US college or university. International students may also apply though approval is on a case by case basis.

Every year, the student loan aid program disburse nearly 60 billion dollars so it is a good choice for get a student loan from the government. The interest rates on federal loans are pretty low.

Private student loans are funded and administered by banks and other financial institutions. These lenders provide student loans at a higher interest rate compared to federal student loans. Some common student loans available are from Citibank and Sallie Mae

You are allowed to apply for both private and federal student loans for your education needs although I would not recommend it.

For some students who have a few student loans to repay concurrently, it can be a financial drain on their family finances. That is where student loan consolidation comes in.

Student loan consolidation basically consolidates all your student loans into one loan so that it is easier to manage and make payments. When you are getting a student loan consolidation whether from the government or the private market, your existing student loans are paid for and erased by the student loan consolidation lender. The balances are transferred to the new student loan consolidation. Thus you start a new loan and only needs to make a single payment each month.

There are many advantages to using student loan consolidation. The interest rates will be lower since it takes the average interest rates of your previous student loans. Thus due to government legislation, the maximum interest rate cannot be higher than 8.25 percent.

It becomes a lot easier to manage a single student loan and payment are easier. The repayment options are quite flexible. For federal student loan consolidation, you can opt to start repaying after you have graduated from school. There are also several other options.

Another beneficial side-effect of student loan consolidation is that it can also improves your credit score. Since you are effectively clearing all your old student loans and taking a new one, your credit score will increase and is important if plan to take other types of loans in the future.

You can apply for a consolidated loan here.

Whatever your choices may be, remember the words of Benjamin Franklin: “Knowledge pays the best interest”.

For more information on student loans in general check out my post about Types Of Federal Student Loans.

From Simple to Compound Interest

Imagine you loan a bank the principal P = 10000 $ at an interest rate of i = 5 %. This is the amount of interest you would receive with simple interest, given the duration t of the loan:

t = 1 year
→ I = 10000 $ * 0.05 * 1 = 500 $

t = 2 years
→ I = 10000 $ * 0.05 * 2 = 1000 $

t = 3 years
→ I = 10000 $ * 0.05 * 3 = 1500 $

As you can see, the interest grows linearly with the duration of the loan. For each additional year, you get an additional 500 $, which is just 5 % of the principal 10000 $. In other words: each year the interest rate is applied to the principal. How could that be any different?

Consider this: At the end of the first year, you’ll receive an interest payment in the amount of 500 $. This means that your bank statement will now read 10000 $ + 500 $  = 10500 $. So why not apply the interest rate to this updated value? This would lead to an interest payment of 10500 $ * 0.05 = 525 $ for the second year instead of just 500 $.

Continuing this train of thought, at the end of the second year your bank statement would read 10000 $ + 500 $ + 525 $ = 11025 $. Again we would rather have the interest rate applied to this updated value instead of the unchanging principal. This would result in an interest payment of 11025 $ * 0.05 = 551.25 $ for the third year.

For comparison, here’s what the final pay out would be for the simple interest plan:

10000 $ + 500 $ + 500 $ + 500 $ = 11500 $

And this is what we would get with the “not simple” interest plan, where we apply the interest rate to the updated amounts instead of the principal:

10000 $ + 500 $ + 525 $ + 551.25 $ = 11576.25 $

The latter is called compound interest. It means that we include already paid interests in the calculation of next year’s interest, which leads to the amount received growing exponentially instead of linearly.

(This was an excerpt from “Business Math Basics – Practical and Simple”. You can get it here: http://www.amazon.com/Business-Math-Basics-Practical-Simple-ebook/dp/B00FXB8QSO/)