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June 28, 2006
The option value of student loan consolidations
Via Phil at Market Power comes this article from the StarTribune.
Thousands of college students and parents are clogging phone lines and rushing to Internet sites in a scramble to refinance college loans before a sharp interest rate increase this weekend.
An almost 2 percentage point interest rate increase for federal student loans kicks in Saturday, and advisers say that not refinancing could cost thousands of additional dollars in interest in the decades after a student enters the work force.
...
"There are very few situations in which it is not advisable for a student who has outstanding loans to consolidate, because they will lock in" relatively low interest rates, said Sandy Baum, an economics professor at Skidmore College in Saratoga Springs, N.Y. Baum is also a financial aid analyst for the College Board education association that produces the SAT college entrance exam.
It is true that students who do not consolodate now will pay more, at least for a while. I'd quibble a little bit with the statement that it will cost "thousands of additional dollars in interest in the decades after a student enters the work force." That's not necessarily precisely true. The rates they will get now are not the lowest in history. If you refinanced last year, you got an even better deal. If interest rates ever get back to where they were about a year ago, then one could wait to refinance until then. It's even possible that sometime in the next "decades" that rates could even go lower, but I admit that would be a gamble.
But the way the student loan system works is that you only get one chance to consolidate. Think of it as if you only get one shot at refinancing your home mortgage. When do you do it? The problem is essentially one of determining when to exercise an option. Whenever the interest rate you get from the consolidation loan is less than the weighted average of your original loans, you are "in the money." But you may not want to exercise the option if you think that rates are going to go down in the near future. So how long do you think it will take for rates to get down to last year's levels again? Your answer will determine whether you think consolidation is a good deal. If you're a recent grad with an average loan balance just starting to make the full payments, you'll probably want to take the deal now. But every situation is different. Your mileage may vary, etc.
I don't have any more loans to consolidate. However, my story is instructive. I figured out early on that consolidation is like an option, so I figured out a way to hedge my bets. I had a number of loans from 4 years of college and some occasional smaller loans during grad school. I consolidated in stages over the years, finishing last year when rates were really low. Knowing that last year's rates were the best I would see in the life of the loan, I went "all in" and gave up any option of consolidating again. I ended up with a weighted average that is a bit higher than if I had timed things perfectly, but better than if I had gone all in right away. (Think of it as getting only one chance to refinance your house, and so doing it one room at a time to keep your options open.) Trust me, its still a better deal than I ever thought I'd get when I graduated from college. Plus, it was an interesting real-world exercise... a chance to practice what I preach.
So my take on this whole consolidation rush is a bit different from the media's. With the exception of those people who just took out loans this year and thus could not have consolidated last year, all of these folks could have done it last year. Either they thought the Fed would stop raising rates sometime in the last 12 months and that lower rates were on the horizon or they missed a really easy call. I think it was the latter.
And that's some real-world macro that has a chance of connecting with college students.
Posted by William Polley at June 28, 2006 9:17 PM
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