Calculating Weighted Average Student Loan Interest Rates
Direct Consolidation Loans help borrowers consolidate multiple federal student loans into one, usually with the goal of simplifying their finances. However, Direct consolidation loans do not give borrowers the benefit of a lower interest rate. Instead, they use a weighted average of the interest rates on the loans included in the new direct consolidation loan, rounded to the nearest eighth of a percentage point.
In other words, you won’t save money on interest if you consolidate federal student loans with a direct consolidation loan. Instead, you can switch from multiple student loan payments to just one, which can make paying off debt easier.
What is a weighted average interest rate?
A weighted average interest rate is the average of the current interest rates on existing student loans, adjusted for how much you owe on each loan. This method is considered more accurate than the average of your interest rates because it takes into account the differences in your debt. In other words, if you owe only $ 1,000 at an extremely high interest rate and $ 10,000 at an extremely low interest rate, those rates will not be weighted in the same way because the balance is much higher with a single rate.
How to calculate your weighted average interest rate for student loans
To get the weighted average interest rate for your student loans, you will multiply the interest rate for each loan by the loan balance, then divide the amount by the total loan balance.
Let’s say you owe $ 5,000 on a 5% student loan and another $ 10,000 on a 3% student loan. Complete the following steps to determine the weighted average interest rate for which you would be eligible:
Step 1: Multiply each loan balance by the corresponding interest rate for the loan.
$ 5,000 x 0.05 = $ 250
$ 10,000 x 0.03 = $ 300
Step 2: Add the products of these calculations.
$ 250 + $ 300 = $ 550
Step 3: Divide the sum of this calculation by the total debt.
$ 550 / $ 15,000 = 0.0366, or 3.66 percent
Step 4: Round off this percentage to the nearest eighth of a percentage point.
3.66% rounds to 3.75%
This weighted average is lower than the simple average of the two interest rates, which would be 4%. This is why the weighted average interest rate is used for direct consolidation loans instead of the actual average of all interest rates combined; the weighted average can take into account that the borrower owes twice as much money on the loan with the lower rate of 3%.
How Direct Consolidation Loans Affect Your Student Loan Payment
Since direct consolidation loans use weighted average interest rates, you won’t save money if you consolidate your federal student loans. Direct consolidation loans often extend your loan repayment time, so you can even pay much more interest in the long run.
There are other drawbacks to direct consolidation loans, including the fact that any unpaid interest on the loans you consolidate becomes part of the original principal balance of your consolidation loan, which means that you will pay interest on a higher balance. . You can also lose out on benefits like interest rate reductions, principal discounts, and loan cancellation benefits, as well as any progress towards income-based repayment plans or Public service loan remission will be reset.
That said, a direct consolidation loan allows you to change your current federal student loans without involving a private company. This means that you may be eligible for federal student loan benefits, such as income-tested repayment plans, as well as deferral or forbearance, if you qualify. A direct consolidation loan will also reduce your monthly payment because your repayment will be spread over a longer period.
Before opting for a direct consolidation loan for your federal student loans, understand your goals. Consolidating your loans this way will likely lower your monthly payment, but it can also increase the total amount you pay in interest over time.
If you are looking to save money, you can choose instead refinance with a private lender; instead of a blended interest rate, you will be offered an entirely new rate, sometimes much lower than what you would pay through the federal government. Just keep in mind that refinancing in this way will take away benefits such as income-tested, deferral, and forbearance.
Before making large movements, use a calculator to determine how much you would pay with both a direct consolidation loan and a private student loan with your preferred terms. You can do this by calculating the weighted average interest rate you might get with a direct consolidation loan, and then comparing it to the student loan rates you might qualify for with a private lender.