Let's talk about student loans…

When it comes to higher education, “loan” has become a four-letter word. We know the horror stories of people struggling under a mountain of debt decades after graduating (or worse, after dropping out of college before earning a degree).

But there are also plenty of people who took out student loans and paid them off in full while still leading a robust life. (I’m one of them!) I am not a financial advisor and this is just my opinion from what I have learned about the marketplace. Please do your own research for what is best for your family.

Think about all the types of loans that people take out all the time: mortgages on a home, car loans, payment plans for a new furnace or solar panels, even credit cards are mini monthly loans that we get to repay (hopefully in full) each month. 

We take out loans to help us purchase items that we believe we need to make our lives more comfortable now or in the future. While a new car can get you to work, an education can get you that job to work at. 

Education loans aren't inherently bad, they are an investment in our future. But, as with any loan, it's important to make informed decisions by taking a hard look at the terms and to not take out more than you can afford to pay off.

What types of student loans are available and which are the best?

In the most basic terms, there are government-backed loans, offered by the federal government or states, and there are private loans, offered by banks and lending companies. 

Federal and state loans are good in that they offer a fixed rate that never changes throughout the life of the loan and they have a cap on how much you can borrow. Each year, the government will set the interest rate for the loans that you take out that year; if interest rates go significantly lower in later years, then you can refinance your loan to take advantage of a lower rate. If rates go up in the years after you first take out your loan, you can just relax enjoying your lower rate.

In general, and here I recommend you do your own research on specific options, but in general, federal and state loans will offer the lowest interest rates, and remember, those are fixed rates, remaining the same regardless of what is going on with the economy at large. 

By contrast, private loans—offered by banks and money lenders—tend to have higher rates at the outset and those rates are variable, meaning they fluctuate with the direction of the economy.

The crazy large student loan amounts you hear about in the news come about when students take out private loans on top of the federal loans, either accumulating a very large principal to start with or dealing with run-away interest that piles on to the principal over time.

Federal direct student loans come in two types: subsidized and unsubsidized. As long as you remain enrolled in college, interest does not accrue on the amount you borrowed from a subsidized loan. By contrast, interest does begin accruing on unsubsidized loans as soon as you receive the money.

You might also hear about Parent Plus loans, which are also offered by the federal government. These loans tend to be fairly easy to qualify for, but they have very high interest rates and come due just about the time that parents will likely be hoping to retire. They are not a good initial strategy. 

The federal direct (subsidized and unsubsidized) and state loans are held by the student, who is obligated to repay the loan themselves, though parents can, of course, offer to help. Parent Plus loans, however, are in the parents’ name, and students are not obligated to pay any of it back. 

Three common reasons a loan could be a good idea

First, a disclaimer. I am NOT a financial advisor. These are simply three of the most common reasons I see people taking out student loans. Do your research and make sure to do what is best for your family at the time.

A loan can ease tight cash flow in the present

Sure, we’d all love to be able to pay for education up-front with no worries about future payments. But tuition costs are likely not going to drop any time soon, so paying for college fully is out of reach for most families. Similarly, we’d love “free money,” outside scholarships or grants and merit aid offered by colleges, to cover the gap we can’t pay for ourselves.

But even with “free money” and our own out-of-pocket contributions, families can face a gap that can’t be filled by a parent taking on a second or third job or the student working full time while trying to attend school full time.

If you know that money will be tight not just when the first tuition payment is due but also into at least the next several months or even until that shiny new job after graduation, a loan can be a good way to ease the cash flow in the present. 

With a student loan, a college kid can build their credit score before graduation

Wouldn’t it be great to graduate from college, degree in hand, a newly minted adult, and be able to rent an apartment or purchase a car without needing a parent to co-sign your lease or car loan?

While repayment on federal direct student loans does not officially begin until six months after graduation, students can begin repaying even earlier if they want and are able. Paying off the interest on an unsubsidized loan, or repaying the loan altogether is a solid way to build your credit score.

Taking out a loan signals to your college that, yes, money really is tight

Why is that a good thing? Should you ever need to go back to the financial aid office to request more aid, the school can see that you have already taken advantage of all your options, which might incline them to agree to a bigger handout going forward.

How much should I borrow?

Again, I’m not a financial advisor, but it is often suggested that you do not take out student loans that total more than 80% of your projected first-year salary after taxes. Sure, it will take more than a year to pay off that loan, since you will still need to pay living expenses, but your salary will increase over time.

How do you know what you’re likely to bring home in your first year after graduation? College Scorecard, produced by the Department of Education, lists this information based by individual schools and often by major as well. 

For example, the median earnings for a psychology major from my state flagship (the University of Massachusetts-Amherst) is $62,236. After taxes, that grad will take home about $44,800. Following the suggestion to limit the student loans to 80% of that after-tax salary, the psychology major would take out no more than $35,800 in loans.

If you can’t find the data for your specific school or major, another good practice is to stick to the maximum allowable through the federal direct loans. Currently, these loans cap at $31,000 total.

How do I get a student loan?

If you are interested in a private loan (by a bank or money lender), you can simply call them or fill out an inquiry on their web site.

To obtain a federal direct student loan, you must first fill out the FAFSA (Free Application for Federal Student Aid) and submit it your your college(s). The Department of Education will use your FAFSA to determine whether you are eligible for subsidized and unsubsidized loans or just unsubsidized. Colleges then have the option to include these loans in your financial aid offer, which is the most common practice; just a vanishingly small number of schools promise their financial aid offers will not include loans. 

Even if your school does not include federal direct loans in their offer, however, you can still notify your school that you intend to take advantage of the loans.

Conclusion

When crafting their financial aid offers, colleges assume that parents and students will all contribute to the cost of higher education. Students can do their part by using their savings, working part-time during the year, working in the summer, and taking out loans in their own name. 

Learn more about student loans and other options for paying for college at the MEFA website.