Weighted Averages and Student LoansSeptember 25, 2016
One of the best reasons to refinance or consolidate student loans is to obtain a lower interest rate, thereby helping you save money over the life of your loan. During the refinancing or consolidation process, you may wonder how your interest rate might change or how the new interest rate is calculated and applied across multiple loans, especially when they include a variety of high and low rates. Both of these questions, as well as a few others associated with a student loan debt consolidation, will be answered as we explore the definition, process, loan association, and calculation of weighted averages.
What is a Weighted Average?
“Weighted average is a mean calculated by giving values in a data set more influence according to some attribute of the data. It is an average in which each quantity to be averaged is assigned a weight, and these weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that many like items with the same value involved in the average.”
While lofty in explanation, the mathematical definition does emphasize one important clue: weighted averages determine the relative importance of each quantity in the average. This kind of emphasis means that important details — like previous loan amounts and interest rates — will not be overlooked. However, to better explain what a weighted average is — and how it pertains to student loans — we want to first explain where it takes places, and with which type of student loans it is associated.
Weighted averages typically only apply to federal student loans that are consolidated by the Direct Consolidation Loan program (not refinanced loans offered by private lenders). When this federally-backed program consolidates multiple federal student loans into one payment, they must somehow figure out what the borrower’s new interest rate will be. This is where weighted averages enter the equation. The new interest rate on the consolidated loan will be a fixed interest rate that is based solely on the weighted average of the interest rates of the loans being consolidated, rather than reflecting current rate trends based on economic conditions or considering the credit history of the individual borrower. This resulting number is rounded up to the nearest one-eighth of 1 percent, and generally reflects a midpoint between the highest and lowest interest rates from the original, individual loans.
How Is the Weighted Average Calculated?
Calculating the weighted average of federal student loans can be achieved through this simple, five-step process:
- Multiply each of your loan’s amounts by its own interest rate. This calculation yields individual “loan weight factors.” You should have as many “loan weight factors” as you have loans.
- Add each of the resulting loan weight factors together to find the total loan weight factor.
- Add each of your loan amounts together to find your total loan amount.
- Divide your total loan weight factor by your total loan amount. To view this number as a percentage, multiply by 100.
- Round the resulting percentage from step five to the nearest one-eighth of a percent. This should present the final interest rate — or the weighted average — for the newly consolidated student loans.
How Are Interest Rates Calculated When Refinancing Student Loans with a Private Lender?
When a person refinances student loans (whether privately or federally-funded) with a private lender, weighted averages usually no longer apply, such as with a consolidation loan from Education Loan Finance. Instead, a new interest rate offer is calculated based on the borrower’s credit history, overall financial health, and current financial market conditions — not weighted averages. Remember, weighted averages only apply to federally consolidated loans. Furthermore, with private lenders, borrowers often have the flexibility to exclude select low-interest portions of their student loan debt from the refinance package if the original rate is more favorable than the rate being offered.
Do the Math
Along with calculating what your weighted average may be, should you choose to consolidate your federal student loans, be sure to find out what your options may be with a private lender’s refinancing program? Refinancing student loans may offer the greatest money-saving opportunities, but it is important to understand that when federal loans are refinanced with a private lender, some benefits — including income-based repayment, loan forgiveness, deferments, and forbearances — may be lost. Our best advice is to compare federal student loan consolidation to refinancing with a private lender and do the math to find out what you may potentially save and what benefits and special considerations your new lender offers before you make any final decisions.