Private student loans should come with a warning label.
For many borrowers, student loans are a necessary tool in the pursuit of the American dream. Used properly, student loans can be an excellent investment in the future.
The problem with student loans is that things don’t always go as planned. When student debt gets ugly, it can mean a lifetime of financial hardships and regret. Private loans don’t qualify for any federal forgiveness program, and rigid repayment terms can make saving for retirement or buying a house impossible.
Ensuring that private student loans are a good decision requires some careful thought and consideration.
Private Student Loan Terms to Understand
Explaining the dangers of student loans is like is a parent explaining the birds and the bees to their teen. The teen’s parents may prefer the teen to abstain from extracurriculars, but in an abundance of caution, they also teach about the safest practices. If the teen is going to engage in an activity that could lead to a lifetime commitment – the parent wants their teen to at least be smart about it.
Similarly, my preference for anyone attending college is to avoid private student loans. However, if you are going to take out private student loans, you need to be smart and protect yourself. You need to practice safe borrowing.
Avoid Fees – Read the fine print on any student loan. Disbursement, origination, or prepayment fees are enormous red flags. Any reputable student loan lender should not have any of these fees.
Watch Interest Rates – Avoiding a student loan catastrophe means keeping a close eye on interest rates. At present, many lenders offer rates below 3%, while others go well over 10%. The higher the interest rate, the harder it will be to pay off, and the more it will cost in the long run.
Shop Around – There are a ton of companies offering student loans. Lending money for college is appealing to banks and other financial institutions because, unlike mortgage debt and credit card debt, it is almost impossible to discharge in bankruptcy. That means borrowers are stuck with their loans for life or until they are paid off. The good news for borrowers is that because there are so many lenders to choose from, there are good deals to be had. Fortunately, shopping around is easy, and it doesn’t take a lot of time.
Spend Smart – Don’t spend $200,000 on a basket weaving degree. There are many options to get credits at less expensive schools and to transfer them to your “dream school.” The sad reality is that many programs are not worth the price of admission. If a reasonably expected salary at graduation isn’t enough to pay off the student loans, it is time to consider a different program or a less expensive school. Make sure the job placement statistics and salary information justify the money that you are spending.
Pay Off the Interest Each Month During School – Student loans accrue interest daily. If you pay off the interest each month, you are ensuring that the balance doesn’t balloon out of control by the time you graduate. This practice is highly recommended because it is also a great way to keep track of your debt balances. Each year as you borrow more student loans, your interest-only payments will increase. It provides a not-so-subtle monthly reminder of your future obligations and the importance of avoiding excess borrowing. Compounding interest is not your friend.
Consider All of Your Options – Starting school at the local community college may not seem ideal, but the credits count just the same. Employers may look at the name of the school on the diploma, but they do not care what percentage of the credits were earned there. If you are deciding between schools, try to get the financial aid offices bidding against each other. The more grants and scholarships you can secure, the less you have to borrow.
Ask yourself: Can I afford this loan?
This question seems like a self-explanatory one to ask, but it rarely happens. Just like you wouldn’t buy a house without knowing what your mortgage payments will be or buy a car without knowing how much you owe each month, you need to know what your monthly student loan payments will be when you graduate.
Unfortunately, the math isn’t simple or straightforward. The private loans you borrow as a freshman will likely be the same private loans you borrow for the next three or four years. When you repay the loans you will be paying back much more than just the principal balance. The loans you borrow years before you graduate may have grown significantly while you were in school due to interest. As you repay the loan, a large portion of your payment will go towards interest. These payments that are mostly interest payments merely represent profits for your lender and do little to knock down your balance. If you sign up for a variable-rate student loan, which is the most common, your interest rate could go up over the years, making your debt even more expensive.
A quick and dirty rule of thumb is that you don’t want your student debt at graduation to be more than your expected starting salary. Some schools like to exaggerate future income numbers, so it is critical to talk with recent graduates and the career development offices to get a realistic idea of what someone at your school with your major can expect to earn.
Have a Plan B if college doesn’t lead to great job right away
Many students finish college, and they either don’t have a job, or they end up in a position with a much lower salary than anticipated.
Federal student loans have programs like income-driven repayment and loan forgiveness. Private student loans have no such protections. With many lenders, the best you will be able to do is a short deferment if you have a financial hardship. During this time, you may not be making payments, but your balance will still grow. If you can’t afford the payments, your credit score will be impacted, your wages may be garnished, and it could make finding a job even harder.
Nobody goes off to college expecting not to graduate or thinking they won’t find a job in their field, but it happens to millions of people every year. If you are smart enough to get your degree and find a good job, then you are smart enough to plan ahead just in case things don’t work out.
It is also worth noting that there are special rules regarding bankruptcy and student loans. Unlike a car loan, mortgage, or credit card debt, student loan debt is almost impossible to discharge in a bankruptcy proceeding. That means the debt will follow you for life if you cannot afford to pay it.
Student debt means more than just bills
Even under the best circumstances, student loans can have major consequences on your finances.
In addition to the large monthly payments that you will have for years, it will also limit your ability to borrow money in the future. Student loans have a major impact on your debt-to-income ratio. When a mortgage company or other lender makes a credit decision, they look at this number. If you have a ton of debt, it can often mean denials or higher interest rates. Many student loan borrowers find that their debt is the reason that they have to delay getting married, buying a house, or having children.
Keep in mind that student loan debt shows up on the credit report of your cosigner as well. That means they will have the same issues concerning debt-to-income ratios as well.
Most Important: Borrow Only What Is Necessary
When I was in law school, I was given this piece of advice: you can live like a lawyer during law school, or you can live like a lawyer when you graduate — but not both. In other words, if you spend a bunch of money while you are in school, you will be living on the cheap long after graduating.
While tuition and books might cost a fortune, there are many ways to keep costs low. Substitute a less expensive option whenever possible. A weekend camping and drinking cheap beer with friends is just as much fun as expensive cocktails at a fancy hotel. If you are not sick of ramen noodles by the time you graduate, you are spending too much money on food.
The sacrifices made during school will make a considerable difference after school.
A Final Private Student Loan Warning…
The Student Loan Horror Stories you have heard are real. Private student loans are a leading cause.
If you are going to borrow, be smart, and borrow responsibly — practice safe borrowing. Your future self will thank you.