5 Things I Wish I’d Know About Student Loans
I have a confession to make: before I was The Prudent Professor, I was Unsavvy Undergrad.
When I started college, I knew little about personal finance and even less about student loans. By the time I finished grad school, I had (and still have) a mountain of student loan debt.
If I'd known more about student loans from the start, I would've made better decisions and ended up with less debt. That's what I share with my students when we discuss student loans and what I'm sharing with you now. Here are five things I wish I'd know about student loans when I started college.
5 Student Loan Lessons I Wish I'd Learned Sooner
#1: You Can Turn Down Student Loans
I'm embarrassed to admit that I didn't know this until my second year of grad school. None of my financial aid advisers had ever told me how to refuse some of my financial aid.
If you get federal student loans, you'll get a notice each year showing how much loan money you're eligible to receive. You can accept only a portion of the money, and even turn down some loans completely. For instance, if you're offered both federal subsidized and federal unsubsidized student loans, you can accept one and refuse the other.
You can also ask that the amount of your remaining loans be reduced. If you're offered more loans than you really need to pay for school, you're at risk of overborrowing. That means you'll be stuck with more debt and larger monthly student loan payments down the road.
Avoiding overborrowing is one of the most important reasons to have a budget for college. If you've budgeted for each year of school, you'll be able to judge if you're taking on more student loan debt than is really necessary. I have a college budget checklist to help you get started; you can get it by filling out the form at the bottom of this post.
#2: Go to a School That Uses Direct Loans
Today, most U.S. colleges and universities participate in the Direct Loan Program. The Direct Loan program distributes financial aid from the federal government to your school on your behalf. In fact, schools must use the Direct Loan Program in order for their students to get federal financial aid. But that wasn't always the case.
Student loans before the Direct Loan Program
When I first started grad school, participation in the Direct Loan Program was voluntary. Students at schools without Direct Loans could still get financial aid, but instead of money going to the school, it was given to private banks instead. So these loans functioned a lot like private student loans. The bank served as the lender, which meant it helped write the terms of the loan.
Since the bank controlled my student loan, I paid a higher interest rate than students who got their loans from the Direct Loan Program. The bank was also able to charge me fees that students in the Direct Loan Program didn't have to pay.
Fortunately, the rule requiring all federal student loans to go through the Direct Loan Program when into effect a year after I started grad school. I was able to get away from higher fee and interest rate bank loans. But that first year of grad school was an expensive one (that I'm still paying for, by the way).
Warning: Some schools still don't use the Direct Loan Program
As stated, most colleges and universities now participate in the Direct Loan Program. However, many for-profit schools and community colleges don't use Direct Loans. Be sure to ask if your school gets federal financial aid through the Direct Loan Program. Otherwise, you may end up taking out much more expensive private student loans to pay for college.
#3: Try to Avoid Variable Interest Rate Loans
There are two types of interest rates on student loans: fixed and variable. Fixed interest rates stay the same for the life of the loan, whether you pay it off in two years or twenty. Variable interest rates can change each year, which means the amount of interest you pay can change each year too.
You might not notice a slight change in your loan's interest rate. Going from 4.25% to 4.33% may only increase your monthly student loan payment a dollar or two. But if you're on an extended repayment plan, which can last up to 30 years, you're likely to see large increases in your interest rate over time.
Variable interest rate loans power the debt treadmill
Variable interest rate loans are one reason some borrowers feel like they can never get ahead on their student loans. In a time of rising interest rates, like the last decade, their student loan payments may increase every year. And more of the money they pay goes toward interest, not paying off the actual amount they borrowed.
If you think or know you'll use student loans to help pay for college, be sure to carefully weigh your options for fixed and variable interest rate loans. If you do end up with some variable rate loans, you don't have to be stuck with them forever. Keep reading to learn how I got rid of my variable interest rate loans.
My variable interest rate student loan story
When I finished my doctorate, right in the middle of the Great Recession, I had a few variable interest rate student loans. At the time, the rate on the loans was around 2.5%, a very low rate that reflected the dire condition of the U.S. economy. Now the economy is in much better shape and those same loans have an interest rate of over 6 percent.
I consolidated all my grad school student loan debt soon after I finished my degree. This allowed me to combine all my loans into one large loan with a very low fixed interest rate (because, again...Great Recession). Consolidating to a fixed rate loan has kept my monthly payments stable and shielded me from the rise in interest rates that occurred as the economy improved.
Consolidating my student loan debt was definitely the right choice for me, but I admit, much of that is due to timing. A student consolidating the exact same amount of debt today would pay a much higher interest rate on their consolidation loan, just because the economy is much better.
#4: Pay Your Unsubsidized Loan Interest
Interest begins accumulating on your student loans the minute you get the money. Who pays the interest and when can make a big difference in your total student loan debt.
If you have a subsidized federal student loan, the federal government pays interest on your loan while you're in school. If you have an unsubsidized federal student loan, you have to pay the interest on the loan, even while you're in school. You need to make these interest payments. Depending on the size of your loan and the interest rate, the payments could be really small, like less than twenty dollars.
What happens if you don't make these small interest payments? Does your future financial aid get canceled? Do you get reported to a collection agency for not paying your bill? Nope. Instead, your loan interest gets capitalized.
How capitalized interest works
If you don't pay the interest on your unsubsidized student loan as it accrues, the government will add that amount onto the principal of your loan (the amount of money you actually borrowed). So if your original loan was for $2,000 and you miss a $15 interest payment, your new loan principal is $2,015.
That's no big deal, right? Except now you're paying interest on the interest of your loan! That means your next interest payment isn't calculated based on the $2,000 you borrowed; it's calculated based on $2,015. If you roll that interest payment back into the principal again, your next interest bill will be even higher.
Capitalized interest also powers the debt treadmill
Capitalized interest is another reason some borrowers feel like they can never get ahead on their student loans. Continually rolling interest into the principal of a loan can add hundreds or thousands of dollars to your total student loan balance. Failing to pay unsubsidized student loan interest as it accrues and letting it capitalize instead is one way students end up with much more loan debt than expected.
Fortunately, I did a pretty good job of paying my unsubsidized loan interest, at least most of the time. Oh, and you should know that any unpaid interest on your student loans get capitalized when you consolidate. So I do have a bit of capitalized interest inside my consolidation loan.
#5: Student Loans Can Make You Unworthy
Of credit, that is. One thing I never really considered was how having a large amount of student loan debt would impact my future credit worthiness.
Credit score versus credit worthiness
Just to be clear, I'm not talking about my credit score here. A big factor in your credit score is how long you've had credit. In that regard, having student loans has actually been helpful, since I now have a credit history extending back more than 20 years. (Umm...yay me? I was in school forevah!). And I have a good record of making my student loan payments on time, which is another big factor in your credit score. So it's possible to have a lot of student loan debt and still have a good credit score.
What I also have is a high debt-to-income ratio and that's a big red flag to banks. Since I already have a lot of debt relative to my income, banks are less willing to lend me money. (Now, anyway. That first year of grad school it was a different story.) Even though I have good credit, my student loan debt makes banks worry that I may not be able to pay back what I borrow. I'm seen as less worthy of credit than someone with the same income but less debt.
I didn't think about future credit worthiness when I was 24 and borrowing student loans. I knew I needed to make my loan payments on time to build good credit. But I didn't think far enough into the future to worry about how my loans would impact my ability to do things like get a mortgage or start a business.
How much should you borrow for college?
To spare your future self these kind of credit (un)worthiness issues, the general rule of thumb is to not borrow more in student loans than you expect to earn annually after you graduate. So if you expect to make $40,000 a year upon graduation, you shouldn't borrow more than $40,000 in student loans.
But you know what? I feel like that's way too much for most students. $40,000 is A LOT of debt. And that's coming from someone who has way more student loan debt than that. (Did I mention I was in school forevah?)
A better approach is to figure out how much you're willing to borrow to pay for school, then find an affordable college based on that number. If I'd done that, I would've gone to a different (read: cheaper) grad school and finished my degree with a lot less debt.
So there they are, five things I really wish I'd know before I borrowed student loans. Before we go, I have another confession to make: I've never regretted or resented my student loans. I'm not among the 36% of grads who say their student loans weren't worth the cost. There's plenty to criticize about the student loan industry, but you'll never see a post here at The Prudent Professor about how student loans are evil and are destroying lives.
The truth is, like a lot of students, I wouldn't have been able to earn my degrees without student loans. I do wish I would've known a lot more about them before I started college, though. That's why I spend a lot of time writing about financial aid and budgeting for college. I want to help students and families avoid learning lessons the hard way, like I did. I want to help them feel knowledgeable about financial aid and confident about college.
Do you have student loan debt? What do you wish you'd known before borrowing student loans? Or are you thinking about student loans? What do you want to know? Let me hear from you in the comments.