Federal direct student loan consolidation isn’t easy to navigate. Determining whether or not consolidation should be done is a critical step in planning a repayment strategy.

Generally speaking, federal student loan consolidation is most helpful for borrowers trying to address eligibility issues. Some borrowers can use consolidation to qualify for student loan forgiveness or income-driven repayment plans. 

Today I’ll cover the basics of federal direct consolidation and include a ton of tips on how to get the most out of consolidation.

What is Federal Student Loan Consolidation?

At the most basic level, a federal student loan consolidation combines multiple federal loans into a single loan.

However, to make sense of the multiple rules and fine print of student loan consolidation, it is easier to look at it from a different perspective.

Federal consolidation transforms an old federal loan into a new federal loan. Normally, the process involves combining multiple loans into a single new loan. However, borrowers have the option of consolidating an individual loan.

The emphasis on the “transformation” is there because the process can either be a good thing or a bad thing. Some borrowers make a mistake and transform a loan they might like into a lousy loan. Other borrowers use consolidation wisely and transform a flawed loan into a better federal loan.

What makes a good loan or a bad loan is all about perspective and circumstances. Perhaps the best way to explain how to utilize this transformation is to give a few examples of what to do and what not to do.

When Should Federal Student Loans be Consolidated?

The classic example of a smart use of federal direct consolidation is Federal Family Education Loan Program (FFELP) loans. Up until 2010, FFELP loans were from private lenders, but the federal government guaranteed them. These loans functioned mostly like federal student loans, but they had a few limitations.

Most notably, FFELP loans are not eligible for Public Service Loan Forgiveness. However, going through federal student loan consolidation transforms FFELP loans into a “federally held” student loan. As federally held loans, the new loans are eligible for more student loan forgiveness opportunities.

Another example of a potentially smart use of consolidation is to consolidate Parent PLUS loans. One of the significant issues with Parent PLUS loans is that they are not eligible for an income-driven repayment plan. Likewise, they do not qualify for Public Service Loan Forgiveness. However, by consolidating into a federal direct loan, the Parent PLUS loan can become eligible for the Income-Contingent Repayment Plan and Student Loan Forgiveness.

These two consolidations make sense for many borrowers because a loan with limited federal program eligibility has been transformed into a new loan with better eligibility.

However, this transformation is not always a smart idea.

When is Federal Student Loan Consolidation a Huge Mistake?

The classic example of Federal Student Loan consolidation being a huge mistake is when a borrower combines a Parent PLUS loan with other federal student loans. As noted in the previous section, a Parent PLUS loan can be consolidated to become eligible for the ICR repayment plan. However, the consolidated loan is not eligible for preferable repayment plans such as IBR, PAYE, and REPAYE.

If a borrower combines many federal loans into a consolidated loan and includes a Parent PLUS loan, the new combined loan is not eligible for IBR, PAYE, or REPAYE. This mistake could easily cost the borrower many thousands of dollars. It may be the biggest mistake someone can make with Parent PLUS loans.

Due to a potentially harmful outcome from consolidation, borrowers must consider program eligibility and progress before consolidating. In some cases, the consolidation will be an essential step; it would be a huge mistake in others.

How do I Consolidate Federal Student Loans?

The actual process of federal direct consolidation is very simple.

The Department of Education will process all of the paperwork electronically. They estimate that filling out the form takes about 30 minutes.

One potential headache that borrowers should avoid would be third-party student loan consolidation services. These “companies,” perhaps more accurately described as scams, advertise a special relationship with the Department of Education. They claim to help borrowers qualify for Income-Driven Repayment Plans and Student Loan Forgiveness. In reality, they function as a middle-man who gets paid and adds no value to the service. In many cases, they end up making errors and making the process even more difficult than necessary.

These companies have gotten so bad that at the top of the Department of Education’s Student Loan Consolidation information page, it displays the following:

As long as borrowers stick with the official Department of Education Student Loan Consolidation page and are careful only to consolidate when necessary, the process is relatively simple.

Other than deciding which loans to include in the consolidation, borrowers will also need to consider their repayment plan options. One of the options will allow borrowers to pick the plan with the lowest monthly payments. However, because multiple plans may have the same low monthly payment, borrowers should research their preferred repayment plan before consolidating. There are several repayment options that borrowers should consider.

Student Loan Consolidation vs. Refinancing

Student Loan consolidation and refinancing are terms that are often used interchangeably. Many lenders that refinance student loans call their service a consolidation.

The best way for borrowers to keep track of things is to look at it this way:

Student Loan Consolidation is only done by the federal government and transforms various federal loans into a federal direct loan. Student loan consolidation does not lower or raise interest rates. The Department of Education takes the weighted average of the loans and rounds it to the nearest 1/8th percent. The one exception is that some borrowers with FFEL Consolidation Loans may have their interest rate increase if they receive a premium interest rate discount from their lender.

Student Loan Refinancing is a process provided by private lenders. They pay off old loans, and in return, the borrower agrees to repay the new loan with the new lender’s terms. Usually, this is done to get a lower interest rate. Both federal government loans and private loans are eligible to be refinanced. Many different companies provide refinancing services, so borrowers need to research their options and understand the consequences of private student loan refinancing.

Important Details to Know Before Starting Federal Direct Consolidation 

Consolidation may result in two loans instead of one – Federal consolidation typically is presented as a way for borrowers to combine all of their federal student loans into a single loan. Many borrowers will end up with two separate loans if they consolidate. This is because the Department of Education keeps the subsidized loans separate from the unsubsidized.

Consolidation is one of the rare opportunities to switch federal servicers – During the student loan consolidation process, borrowers have the option of selecting their preferred loan servicer.

The credit score impact is minimal – When consolidating borrowers may see their credit score move slightly. For some borrowers, it goes up because the old loans show as being paid in full and it is usually better to have one large debt than many small debts. Others see their score drop because their student loans were the oldest item on their credit score and average credit age is a factor. Generally speaking, consolidation really doesn’t move the credit score needle much. The money saved is a much bigger factor.

Hold off on Consolidation if you are about to buy a house – A ton of major changes on a credit report can cause some concern with mortgage companies. Borrowers who are about to buy a house should discuss consolidation with their mortgage company before starting the process.

The consolidation process can take months – Filling out the form may only take 30 minutes, but the actual process may take months. To consolidate, all of the old loans must be paid off in full, and doing this math takes the Department of Education some time. Don’t be surprised if there are some minor issues with this process.

After the math has been done, the borrower should receive a letter giving them one last chance to opt out of the consolidation. Though no action is required from the borrower during this time, the consolidation process is a bit time-consuming.

Consolidation can be used as a way out of default – Borrowers who have fallen way behind on their student loans can use consolidation as a quick fix to get out of default. However, borrowers also have the option to rehabilitate their loans before consolidation. There are several factors borrowers should consider when deciding between rehabilitating and consolidating their defaulted loans.

Private loans cannot be included in a federal consolidation – Being able to transform a private student loan into a federal government loan would be great, but it is not an option.

There is no minimum credit score or income requirement – Unlike refinancing with a private company, all federal borrowers are allowed to consolidate their federal loans. There is no credit check.