Practice Management Toolkit

Debt Management

Is Loan Consolidation Right for You?- Part I

With interest rates at historic lows, record numbers of Americans have been taking out home mortgages, home equity loans and lines of credit, auto loans, and educational loans. In fact, rates are so attractive they are spurring people to borrow more money than ever before.

The flip side to this phenomenon is improved terms for educational loan repayment. In fact, if you have not done so already, now is an excellent time to pull out all those loan papers to review the terms of your loans. For those of you with federal educational debt an important date is approaching. Each July 1st the rate for federal loans is adjusted for the following 12-month period.

Would you benefit by refinancing one or more of your educational loans? Should you consolidate all the loans to lower your payments by locking in a reduced interest rate, extend the terms, or both? These are just a few of the questions to ask yourself as you examine your personal financial situation. Let’s take a look at some of these topics.

What Are Your Options?

It's quite possible you have a substantial amount of educational debt. As a result, you now face the added challenge of managing a repayment program with your present cast flow. Given the general trend of interest rates over the past few years, it’s quite likely your existing loan rates are higher than the current rate for new loans. If that’s true in your case, you may want to consider modifying the terms of those existing loans. Contact the financial institution serving your loans and ask what your options are. Typically, you have a number of choices: 1) do nothing and follow your present repayment schedule, 2) accelerate the payments and pay the loans off early, 3) consolidate your loans but pay them off in the shortest period of time, or 4) consolidate your loans and extend the repayment period.

Researching these options will require some time and patience. The guidance you receive may vary depending on where you get your information. You may find it helpful to write down the date and time of each call as well as the name and phone number of the person who assisted you. Should you need to call back for clarification, at least you’ll have a point of contact. There’s no sense having to explain your situation and objective to a new representative every time you call.

Unlike home mortgages, you cannot refinance federal school loans every time there is a favorable move in interest rates. However, you can consider the next best option, loan consolidation.

Should You Consolidate Your Federal Educational Loans?

Loan consolidation is the process by which several loans with varying terms (principal, interest rate, and length) are combined into one loan. With the new “consolidated” loan, you give yourself the opportunity to reset both the interest rate as well as the repayment period. Because rates are at historically low levels now, you may find that you can reduce your monthly payments for a considerable savings.

Bear in mind that loan consolidation is a service offered by for-profit companies. The process should generally be the same among different consolidators. Where differences exist are in the quality of services (speaking with a live representative versus a circuitous call network that eventually leads to a human voice) and type of incentives programs. In the following examples we’ll use actual loan rates obtained from the website of Collegiate Funding Services (CFS) at www.cfsloans.com. If you prefer, you can call CFS at (866) 312-7227 for more information. The American Dental Association (ADA) has chosen Collegiate Funding Services to assist ADA members with student loan consolidation through the ADA Member Advantage Program. In fact, ADA members are eligible to receive an additional discount from Collegiate Funding Services as part of the ADA Member Advantage program. You could also contact Sallie Mae (888-2-Sallie and www.salliemae.com) or do your own research on this subject on the Internet.

The following examples are provided solely for the purposes of illustration, and the loan rates cited are drawn from the Collegiate Funding Services website. For current rates and terms, call CFS or visit their website. (NOTE: Use this information to lay the foundation for your loan consolidation analysis, then check and compare the terms offered by other companies and financial institutions. In these examples, the values will be rounded up or down and listed to the nearest whole dollar.)

Private versus Government Loans

The loan consolidation companies such as Collegiate Funding Services, Inc. also can help to consolidate private loans, but the terms and conditions are much different. Review the particulars of your loans before talking to a loan counselor. Be advised that one of the major differences with private loan consolidation is that the interest rate is not fixed, but variable. Nonetheless, ask what incentive programs each company offers that may make combining your private loans worthwhile.

Just remember that private loans are handled differently, so have your loan documents available when you speak to a counselor. Typically, the consolidators can help you merge multiple loans into one with the loan rate derived using a weighed average method.

Compare Your Loan Repayment Options

The following examples have been created to illustrate several options to restructure your educational loans. There is no “correct” choice or “best” way to handle this matter, just a series of choices. Look at each example to determine which one or ones best suit your particular financial situation. It will be assumed that you have $100,000 in federal loans and are either already repaying those loans or you will graduate from dental school in a few months and soon enter your repayment “grace period.”

Example #1: Let’s assume you have loans totaling $100,000 set at 4.125% with a 10-year repayment period. Under these terms, your loan payment would be approximately $1,018 per month or $12,216 per year. Assuming you made all your payments on time the $100,000 loan would be paid off in 10 years (Figure 1). The total loan interest paid over those 10 years would amount to $22,208. (Note: A rate of 4.125% was chosen, because federal loans granted after June 1998 had an interest rate of approximately 4.06% rounded to 4.125%).

Example #2: Take those same $100,000 loans and consolidate them into one loan with a new, lower fixed interest rate. See what happens to the monthly payment when the repayment period is extended beyond 10 years. As of this writing the consolidated rate is 3.46%, rounded to 3.5% and subject to change every July 1st. ADA members using Consolidated Funding Services, Inc. can obtain a 0.25% rate reduction merely by setting up automatic monthly repayment.

If your loan repayment “grace period” has passed, you can still consolidate your loans at the current 4.125% rate, but not at either of the reduced rates (3.5% or 3.25%). As you can see from the values in Figure 2, the monthly and yearly payments decrease considerably when loans are stretched between 20 and 30 years. Of course, the trade off for a reduced monthly payment and longer repayment period is a substantial increase in the amount of loan interest. However, the relative merits of these repayments options (standard 10-year period versus 20, 25, or 30 years with loan consolidation) depend on what you do with the monthly “savings” created when the payment is reduced.

Loan Consolidation – The Value Is In the Numbers

Interest Charges vs. Use of Monthly “Savings”

With a 10-year loan, the total amount of interest paid in our example is estimated to be $22,208. If the $100,000 loans were consolidated with repayment extended to 20 years, at the reduced rate of 3.25%, the interest charges increase by $13,919 to $36,127. Lengthen the loan to 30 years after the grace period, and the finance charges rocket to $74,474 or $52,266 above what you would have paid over the course of just 10 years.

But thanks to recent tax law changes, more of that interest (up to $2,500) may be tax deductible although income restrictions apply. As you might expect, this interest deduction is phased out for married couples with income in the $100,000 to $130,000 range and individuals who make more than $60,000 but less than $75,000. Yet, couples below the $100,000 limit and individuals who make less than $60,000 get the full tax write off.

The flip side to paying more in finance charges over a longer loan period is a reduction in the monthly payment. Lower payments free up cash for other purposes. In fact, the monthly savings can range from $405 to as much as $583 as you can see in Figure 2. Those savings are enough to permit you to make the maximum IRA contribution of $3,000 each year with dollars to spare. Money “saved” above the $3,000 IRA contribution can fund personal (taxable) investment accounts.

If you are disciplined, you can invest the “savings” in accounts that have the potential to appreciate in value during the extended 20-, 25-, or 30-year repayment periods. Meanwhile that educational loan payment remains fixed for the length of the term you selected. As a result, you are able to address three needs: 1) pay off your educational loans with a sound financial strategy, 2) invest for retirement, and 3) fund personal (taxable) accounts for short-term needs.

(Note: The following calculations here and in Figure 2 were computed as though the savings were invested each year as a lump sum rather than putting the “savings” aside each month.)

Savings for a 20-year repayment:

Even if you simply put the savings in a money market account, you still come out ahead by consolidating your loans. Let’s say you decided to set up a consolidated loan of $100,000 at 4.125% and lengthen the repayment period from 10 to 20 years. You’ll ”save” $405 per month over the $1,018 payment for the conventional 10-year non-consolidated loan(s) as seen in Figure 2. That’s $405 per month or $4,860 per year that you can save or invest. Multiple that $4,860 yearly savings by 20 years and you’ll accumulate $97,200 in contributions in the money market account plus interest. With the 20-year loan you will pay $47,021in finance charges compared to just $22,208 with a 10-year loan. Although you pay $24,813 more in interest ($47,021 - $22,208) with the longer loan, you wind up with $97,200 in “savings” for a net gain of $50,179 plus interest ($97,200 - $47,021).

If you invest your monthly savings you have the potential (but certainly no guarantee) to amass more (or less) than $97,200 after 20 years. Of course, you always have the option to invest the “savings” in conservative, fixed income assets should you care to do so.

Now let’s determine what the “savings” might be from a 25-and a 30-year loan.

Savings for a 25-year repayment:

The monthly “savings” for a 25-year loan of $100,000 at 4.125% increases to $483. That’s an estimated $5,796 per year that you could simply put in the bank and see it grow to $144,900 ($5,796 x 12) plus interest over next 25 years. The finance charges, however, now balloon to $60,420 from $22,208 with the 10-year loan. The added interest you pay may be $38,212 ($60,420 - $22,208), but your total “savings” is more than $144,900. The difference between the added interest paid during those 25 years and the total savings is over $106,688 ($144,900 - $38,212), and that money can be put in a savings vehicle or invested regularly over the course of the entire 25-year repayment period.

Savings for a 30-year repayment:

In this final example, the “savings” for a 30-year loan of $100,000 at 4.125% increases to $533 per month and $6,396 per year. Those annual savings can grow to more than $191,880 plus interest over 30 years. But note that the total finance charges rise dramatically to $74,474 from $22,208 for the standard 10-year loan with $52,266 ($74,474 - $22,208) of additional finance charges. But under these terms the total “savings” is an estimated $191,880. The net “savings” with the 30-year loan now approaches $140,000 ($191,880 - $52,266), and that is money you can use in retirement.

As you can see from these simple examples, loan consolidation can be viewed either negatively or positively. Yes, you will pay more interest as you lengthen your loans, but if you actually invest the “savings,” you can wind up with more money in your pocket than you would otherwise. These examples do not include the added benefit of a student-loan interest tax deduction or even a modest annual rate of return received for investing the monthly and yearly “savings.”

If you have not given loan consolidation serious consideration, give it some thought to see if it is something you wish to pursue. Who knows, you might be pleasantly surprised as to how it might benefit you.

This topic is continued in Part II

About the Author

W. Patrick Naylor, D.D.S., M.P.H., M.S. is an adjunct professor at the Loma Linda University School of Dentistry where he lectures on personal finance and investing. He is author of the book, 10 Steps to Financial Success, A Beginner’s Guide to Saving and Investing (John Wiley & Sons, Inc.). Dr. Naylor also wrote a dental text, Introduction to Metal Ceramic Technology (Quintessence Publishing Co.).

Together with Loma Linda University he created a self-paced personal finance CD-ROM entitled “Personal Finance Series for Health Professionals” based on 16 hours of lecture. The CD-ROM consists of four parts: Series #1 - Savings and Investment Basics, Series #2 - Investment Selection I – Mutual Funds, Series #3 - Investment Selection II – Stock Selection and Investment Tracking, and Series #4 - Investing in Tax-Deferred Accounts. The topics in all four of the series are of general interest, but Series #4 contains a section devoted to retirement plans for the dental office.

The personal finance CD-ROM can be purchased from the Loma Linda University School of Dentistry for $35.00 (including shipping in the continental U.S.) by calling (909) 558 - 4685 or sending a check for $35.00 to Continuing Education, Loma Linda University, School of Dentistry, Loma Linda, CA 92350. Loma Linda School of Dentistry also has several dental CD-ROM programs available for sale.

Dr. Naylor’s personal finance book can be obtained from any of the large, online book retailers, such as www.Amazon.com, or ordered by a local bookstore. His dental textbook is available through the Quintessence Publishing (800-621-0387 or 630-682-3223).