The truth behind 5 common student loan myths

Key points

• If you’re not clear about how student loans work, it can cost you money or ruin your credit.
• If you’re thinking of consolidating your loans, know that it actually doesn’t reduce your interest rate.
• And refinancing may not save you money.
• Sorry to say, but the forgiveness fairy isn’t going to erase your student loans.

Considering how complicated student loans can be, it’s no wonder there are some major misconceptions out there. Like consolidating your various student loans always saves you money. That’s not necessarily the case.

What other pieces of misinformation about student loans could cause you to make bad decisions that will cost you money or ruin your credit? Here are the top five that I’ve come across again and again over the years.

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Myth #1: Consolidating your federal loans will reduce your interest rate

Consolidation refers to combining two or more federal education loans into a new loan. It is not the same as refinancing federal and private student loans. Most people consolidate to streamline repayment by combining multiple loans into a single loan. But you shouldn’t assume that your interest rate will go down.

The interest rate on a consolidation loan is based on the weighted average of the interest rates of the old loans, rounded up to the nearest 1/8th of a percentage point. This is in contrast with a refinance, which bases the new interest rate on the current credit scores of the borrower and the cosigner (if there is one).

The weighted average interest rate will be between the highest and lowest interest rates on the old loans. And as you’ll see, this new rate won’t really lower your overall interest rate or monthly payments.

For example, if you have two loans, a $7,500 undergraduate loan at 5.045% and a $20,500 graduate student loan at 6.079%, the weighted average is 5.802% [($7,500 x 5.045% + $20,500 x 6.079%) / ($7,500 + $20,500)].

That 5.802% is less than 6.079% but greater than 5.045%. Rounding this up to the nearest 1/8th of a percentage point yields 5.875%.

The weighted average is sometimes mischaracterized as reducing the interest rate on the student loans, since it is lower than the highest interest rate. But it is also higher than the lowest interest rate.

The fact is, the use of a weighted average more or less preserves the cost of the loan.

Using the previous example, let’s consider the loan payments before and after consolidation:

• Before consolidation: The monthly payment on $7,500 at 5.045% on a 10-year loan is $79.71. The monthly payment on $20,500 at 6.079% on a 10-year loan is $228.41. The sum of the two monthly loan payments is $308.12.
• After consolidation: The monthly payment on $28,000 at 5.875% is $309.10, or less than a dollar more per month.
• Impact of rounding: Without the rounding up the weighted average to the nearest 1/8th of a percentage point, the monthly loan payment at 5.802% would have been $308.08, or four cents less per month than the loan payments before consolidation. The rounding up of the interest rate increases the loan payment slightly.

The monthly loan payment on a consolidation loan will usually be close to the sum of the monthly loan payments on the old loans, if the repayment plans and repayment terms are the same. The main exception is for small loans, where the monthly loan payment is rounded up to the $50 minimum payment. Including such loans in a consolidation loan will yield a lower monthly loan payment when the new payment is greater than the minimum payment.

There is a drawback to consolidating your loans: Since a consolidation loan replaces the old loans with a single new loan, it prevents you from targeting the highest-rate loan for quicker repayment. Accelerating repayment of the highest-rate loan, known as the avalanche method, saves money by reducing the average interest rate.

Myth #2: Cutting the interest rate in half cuts the loan payment in half

Borrowers often misjudge the impact of interest rates on loan payments. Cutting the interest rate in half on your student loans will not cut the monthly loan payment in half. Instead, cutting the interest rate in half reduces the loan payment by only about 10% to 20%, depending on the interest rate and repayment term.

Reducing the interest rate does not cut your student loan payment as much as you might think because a good part of the loan payment goes to principal, not interest.

For example, consider a $10,000 loan at 5% interest on a 10-year repayment term. The monthly loan payment is $106.07. Of that, $41.67 of the first loan payment is interest and $64.40 is principal.

As the principal loan balance is paid down, less of each payment is applied to interest and more is applied to principal, accelerating progress in paying down the loan balance. By the end of the fifth year of repayment, $23.76 of the payment is applied to interest and $82.31 is applied to principal.

You may be assuming that the interest savings from refinancing your student loans at a lower interest rate are entirely due to the lower interest rate. But refinancing a student loan at a lower fixed interest rate often requires a shorter repayment term, because lenders factor in the likelihood that interest rates will increase as time passes when setting their interest rates.

Most of the savings come from the shorter repayment term, not the lower interest rate, because there is less time for interest to be charged on the loan. Also, a shorter repayment term yields a higher monthly loan payment, with more of the payment being applied to principal, paying down the loan balance more quickly.

This is why it is important to consider several factors when you compare loans, including the monthly loan payment and total payments over the life of the loan, not just the interest rate.

While cutting the interest rate in half does not cut the monthly loan payment in half, cutting the amount of debt in half does cut the loan payment in half. If you want to reduce your loan payments, borrow less.

Curiously, cutting the interest rate in half yields about the same reduction in total payments over the life of the loan as cutting the repayment term in half. Similarly, doubling the interest rate has about the same impact as doubling the repayment term.

For example, suppose we have a $10,000 loan at 8% interest with a 20-year repayment term. The monthly payment is $83.64 and the total payments are $20,075.98. If we cut the interest rate in half to 4%, the monthly payment is $60.60 and the total payments are $14,543.28.

Instead, if we cut the repayment term in half to 10 years, the monthly payment is $121.33 and the total payments are $14,559.16. Notice how $14,543.28 and $14,559.16 are pretty close, only $15.88 apart. The difference in the percentage reduction in total payments is 0.08%. Such small differences are often masked by rounding.

Myth #3: Refinancing student loans always saves you money

If you qualify for a lower interest rate when you refinance, you might save money. But many factors, and not just interest rates, can affect how much you actually save.

First, the interest rate isn’t always lower, even if your credit score has improved. Sometimes, prevailing interest rates have increased from when you borrowed the student loans. If you’re refinancing without a cosigner, your credit score has to beat your cosigner’s credit score, too.

If you have multiple loans, the new interest rate may be lower than the interest rates on some of your loans, but higher than the interest rate on the rest of your loans.

If you have a federal student loan, you already probably have lower fixed interest rates than private student loans unless you have excellent credit or your federal loans are from several years ago, when interest rates were higher.

A switch to a longer repayment term will yield higher total payments over the life of the loan, even with a lower interest rate. More time for interest to accrue increases the cost of your loan.

Also, refinancing federal student loans into a private student loan will cause you to lose the superior benefits of federal loans. Some of these benefits, such as subsidized interest during a deferment, student loan forgiveness and the payment pause and interest waiver, can save you money.

Myth #4: Interest doesn’t accrue during periods of non-payment on student loans

Sometimes, borrowers mistakenly believe that if they stop making payments on their loans, interest stops accruing as well. But the interest doesn’t magically stop.

Interest is charged on your student loans every day, even if you don’t make a payment. If you skip payments, your loan will get bigger faster because the unpaid interest will be added to the loan balance, causing interest to be charged on interest.

Interest is charged during and after a forbearance, delinquency or default.

If you don’t make payments on your loans for a decade or two, the loan balance may double or even triple. An extended period of non-payment causes the loan balance to balloon because of compound interest, not just the collection charges on a defaulted loan.

Myth #5: All federal student loans will be forgiven eventually

Some politicians have promised voters that all or part of their student loans will be forgiven. These promises have not yet been fulfilled.

Federal student loans have many options for targeted loan forgiveness and discharge, such as Public Service Loan Forgiveness, Teacher Loan Forgiveness, Closed School Discharges, Death Discharges, and the Total and Permanent Disability Discharges. Borrowers who don’t satisfy the eligibility requirements for these programs are often disappointed when their loans aren’t canceled.

Assuming that your student loans will be forgiven can cause you to take steps that hurt your finances. You may also fail to take steps that will help your finances.

Moral hazard refers to a failure to protect yourself against risk when you believe that you will be sheltered from the consequences of your actions.

For example, if you believe that your student loans will all be forgiven, you might borrow more than you need. Why not splurge, if someone else will be paying off your debt?

Counting on student loan forgiveness can cause other problems besides borrowing too much money. You might skip loan payments, choose a longer repayment term to reduce the loan payments, or avoid refinancing your student loans while waiting for forgiveness.

Instead of waiting for the forgiveness fairy to wave a magic wand and wipe out your student loans, take action to address your situation yourself. You make your own luck.