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Student Loan Consolidation

Student Loan Consolidation

Question

Should I consolidate my student loans onto my line of credit?

Executive Summary

Whether or not you consolidate your student loans onto your line of credit depends on four key factors: The first factor are the terms of your student loans. Loan terms will determine when and how much interest you are charged. The second factor is the potential tax credit savings associated with student loan debt. The more tax credits a student loan accrues; the less favourable consolidation becomes. The third factor are loan forgiveness programs. Various programs exist for forgiving student debt, but in order to take advantage of these programs you cannot consolidate your student debt onto your line of credit. The fourth factor are interest rates. Interest rates determine the value of each debt product, as they change over time, the advantages and disadvantages of consolidation will change as well.

Background

Debt consolidation refers to the financial maneuver of using one loan to pay off another form of debt. As you are paying off one form of debt with another loan, you transfer the balance of one loan onto another loan. This is typically done to take advantage of more favourable terms on one of the loans, such as a lower interest rate or a better repayment schedule. New residents often ask, does consolidating my student loans onto my line of credit make financial sense?

Review of Literature

In the case of medical student loans, debt consolidation often refers to the decision of paying off your student loans with your available line of credit balance. Most medical students are offered large lines of credit at the start of medical school, and these lines of credit typically have favourable interest rates (such as Prime – 0.25%). The goal of student debt consolidation is simple – you want to pay less interest costs over the term of your loan. Previously, the interest rates on student loans were significantly higher than the interest rate on a medical student line of credit (e.g.: Prime + 5%). This made the decision pretty easy; you would consolidate your high interest student loans onto your line of credit as soon as you finished medical school as you would save interest costs. However, there have been a number of legislative changes to student loan interest rates which have decreased (or eliminated) interest charges on student loans. Furthermore, potential student loan tax credits and loan forgiveness programs make the decision to consolidate student loans much more nuanced. To help navigate this complex decision, we will walk through a step-by-step process that you can use to accurately compare the costs of keeping your student loans to the costs associated with consolidating the student loans onto your line of credit.

Determining Factor 1: The Terms of Your Student Loan

In determining if debt consolidation makes sense, the first important factor are the terms of your student loans. It is important to note that most students have both federal and provincial student loans, and each carries a different set of terms. In particular, it’s important to review the interest rate, grace period, and repayment terms of your student loans. We have summarized some of these terms in the table below, but it is crucial that you review your own student loan terms before making a decision.

Interest Rate Fx = FixedFl = Floating When Interest Begins to be Charged on Loan Loan Repayment Begins
Federal Student Loans
Canada Fx: Prime + 2%
Fl: Prime + 0%		 6 months after the conclusion of Medical School
 6 months after the conclusion of Medical School
Provincial Student Loans
Alberta Fx: Prime + 2%
Fl: Prime + 1%		 6 months after the conclusion of residency 6 months after the conclusion of residency
British Columbia 0% N/A 6 months after the conclusion of Medical School
Manitoba 0% N/A 6 months after the conclusion of Medical School
New Brunswick Fx: Prime + 2%
Fl: Prime + 0%		 At the conclusion of Medical School 6 months after the conclusion of Medical School
Newfoundland and Labrador 0% N/A 6 months after the conclusion of Medical School
Northwest Territories Prime - 1% 6 months after the conclusion of Medical School 6 months after the conclusion of Medical School
Nova Scotia 0% N/A 6 months after the conclusion of Medical School
Nunavut Prime – 1% 6 months after the conclusion of Medical School 6 months after the conclusion of Medical School
Ontario Prime + 1% At the conclusion of Medical School 6 months after the conclusion of Medical School
Prince Edward Island 0% N/A 6 months after the conclusion of Medical School
Quebec Prime + 0.5% 6 months after the conclusion of Medical School 6 months after the conclusion of Medical School
Saskatchewan Fx: Prime + 2%
Fl: Prime + 0%		 6 months after the conclusion of Medical School 6 months after the conclusion of Medical School
Yukon Prime + 2% 6 months after the conclusion of Medical School 6 months after the conclusion of Medical School

As you can see, interest rates vary between provinces. In addition, some jurisdictions give you the option of a fixed or floating interest rate (floating interest rate means that the interest rate may change during your repayment, whereas a fixed interest rate stays the same during repayment). Furthermore, some provinces do not charge any interest on student loans, which means that you are only responsible for paying back the funds that you were leant once the repayment period begins.

For the student loans that do incur interest, they typically begin incurring an interest charge when the student finishes their full-time studies (often following a grace-period of 6 months). In most cases, this grace period starts as soon as a student finishes medical school. That being said, in some provinces (such as Alberta), residents are considered full-time students and will not incur interest charges until after completing residency. In contrast to the variable timing of interest charges that occurs with student loans, when you use your line of credit, you begin to incur interest charges immediately.

Determining Factor 2: Tax Benefits

The next important point of information is that student loan interest has a unique tax benefit, as interest paid on student loans is eligible for a student loan tax credit. This is important to note as the interest paid on your line of credit (even if you consolidate your student loans onto your line of credit) is not eligible for this tax credit.

Lesson 2 of Module 2 focuses on taxes, and reviews the difference between tax credits and tax deductions in more detail. In brief, a tax credit reduces the amount of tax payable to the government when you pay your annual income tax. The actual value of a tax credit is equal to the amount of the tax credit multiplied by the lowest marginal federal and provincial tax rate. At the time of writing, the lowest marginal federal tax rate is 15%, and provincially, the lowest marginal tax rate in BC is 5.06%.

Determining Factor 3: Loan Forgiveness

Another thing to consider is loan forgiveness. Depending on your residency program, province of residency, and location of training/future practice, there may be programs that will forgive portions of your student loan debt. Generally, these programs can only be taken advantage of if you maintain your student debt as student loans, and will not apply if you consolidate your loans onto your line of credit.

Some of the common programs available to residents in BC include:

Determining Factor 4: Interest Rates

Finally, it is important to note that interest rates can change depending on prevailing economic conditions and legislative changes. It is important to keep an eye on the prime interest rate and re-evaluate your debt in the event of interest rate changes.

Practical Example

Sam is an incoming R1 and is wondering whether it makes sense to consolidate her student loans onto her Line of Credit (LoC). Sam is graduating medical school with a total debt of $150,000. Of that $150,000 debt:

  • $70,000 is on her LoC (with an interest rate of Prime – 0.25% = 2.2%)
  • $80,000 are in student loans

Sam’s student loan debt is divided between provincial and federal loans, with $40,000 held in British Columbia Student Loans and $40,000 held in Federal Student Loans. Should Sam pay off her student loan balances with her line of credit?

Step 1: Review the terms of your student loans

The first step in deciding on debt consolidation is to determine the terms of your student loans.

In taking a look at our case, Sam’s student loan debt of $80,000 is divided between provincial and federal loans, with $40,000 being British Columbia Student Loans and $40,000 in Canada Student Loans. As British Columbia Student Loans do not incur interest, it doesn’t make sense to consolidate these loans onto Sam’s line of credit, as the line of credit begins to incur interest immediately, whereas the BC loans are interest free. As such, Sam should simply repay the BC student loans gradually over her student loan repayment term. Even if Sam has to use her line of credit to pay the monthly student loan payments, she is saving money in interest payments by only putting the minimum amount of loan payment on her LoC.

Sam also has federal student loans, which begin to incur interest 6 months after medical school finishes. That means Sam has six months to decide whether or not to consolidate her federal student loans onto her Line of Credit. While on first glance, it seems like the interest rate on her line of credit (Prime – 0.25%) is more favourable than the floating interest rate (Prime) charged on her Canada Student Loans, it’s important to review the potential tax implications of paying interest on student loans.

Step 2: Calculate the potential tax credit savings for student loan interest charges

As mentioned already, if your student loans do not incur interest charges in residency, the decision is simple – do not consolidate your loans onto your Line of Credit (which incur interest immediately). However, if your student loans begin to incur interest during residency, we now have to compare the interest charges on your student loan to the interest charges on your line of credit.

If Sam uses her line of credit to consolidate her federal student loans, she will be paying off the federal student loans with her line of credit. As such, her line of credit will now carry an additional $40,000 balance. You can calculate the interest charge by multiplying the LoC interest rate by the additional balance. For Sam, the annual interest charge on her $40,000 of consolidated student debt is $880 ($40,000 x 2.2%).

So how much interest would Sam have to pay if she kept her student loan?

Assuming Sam chooses the floating interest rate (Prime + 0%), the interest rate on Sam’s federal loan would be 2.45% (Prime). The annual interest charge would work out to $980 ($40,000 x 2.45%). While this interest charge is more than the interest charge if she used her Line of Credit, student loan interest has a unique tax benefit, as interest paid on student loans is eligible for a student loan tax credit. As previously mentioned, interest on a Line of Credit is NOT eligible for tax credits, even if the Line of Credit was used to pay off student loans.

Therefore, if Sam keeps the $40,000 as a federal student loan, her annual interest charge of $980 is eligible for the student loan tax credit. As mentioning in the Review of Literature section at the time of writing, the lowest marginal federal tax rate is 15%, and provincially, the lowest marginal tax rate in BC is 5.06%. The value of Sam’s tax credit works out to a federal tax credit of $147 ($980 x 15%) plus a provincial tax credit of $49.59 ($980 x 5.06%), for a total of $196.59. That tax credit can be used to reduce the amount of tax owing on any tax return for up to 5 years. It is essentially a gift card for your taxes, that expires in 5 years.

As Sam is eligible for a tax credit of $196.59, that means that her net interest charge is $783.51 ($980 - $196.59). That’s almost $100 less than the interest payment she would have paid if she consolidated her loan onto her line of credit, which we calculated above to be $880.

Therefore, assuming Sam can make use of her tax credit, she should keep her federal student loan rather than consolidate her debt onto her line of credit.

Interested in comparing your own interest payments on your student debt? You can compare your own interest costs using the interactive Financial Pulse calculator here:

Whether it will be more favorable using your line of credit will depend mostly on the interest rate differential between your line of credit and student loan. For instance, if we compared debt consolidation with a federal loan that carried a fixed interest rate of Prime + 2%, consolidating the student loan onto the line of credit would be more advantageous.

Before making the final decision, there is one more important variable to consider - loan forgiveness programs.

Step 3: Explore Loan Forgiveness Programs

Sam takes a look into the available loan forgiveness programs, and realizes that in she may benefit from the Canada Student Loan Forgiveness Program for Family Doctors and Nurses. Sam is originally from Northern BC, and is hoping to open a family practice in her small hometown upon graduation. By paying off her federal loans today with her Line of Credit, she will be unable to benefit from these programs.

Step 4: Monitor Interest Rates

Sam is up to date on the latest interest rates on all three of her loans, her Line of Credit, Provincial Student Loans, and Federal Student Loans. She makes a plan to check-in on interest rates once a year, and sets a calendar reminder to make sure she does not forget.

Case Resolution

In this case, Sam should not consolidate her federal student loan of $40,000 onto her line of credit as she will save more money when accounting for the impact of the student loan interest tax credit. Additionally, she hopes to one day take advantage of a federal debt relief program that would minimize her student debt. Finally, she should not consolidate her BC student loan of $40,000 onto her line of credit as it does not incur interest.

Actionable Conclusion

When deciding whether to consolidate your student debt, be sure to take the following steps in your decision making process:

  1. Review and understand the terms of your student loans
  2. Calculate the potential tax credit savings for student loan interest charges
  3. Explore Loan Forgiveness Programs
  4. Monitor Interest Rates

References