Understanding Your Student Loans

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This weekend I was able to attend a beautiful high school graduation party for my cousin’s daughter.  This year approximately 3.6 million students were expected to graduate from high school.  If you or someone you love was in that group it is important that you get educated when it comes to student loans.  Unfortunately the cost of college is rising faster than inflation and understanding how the financing works is one of the most important lessons you may ever learn.  Here are some basics about federal and private loans you should know before you or your child heads off to college.

Federal Student Loans

Not all loans are the same.  One of the first things you should know is whether or not the loans are federal or private.  Federal student loans are offered through a loan program from the U.S. Government.  That part is pretty easy to understand.  They also contain features that are different than private loans.  Federal loans typically offer lower interest rates and a variety of repayment options that are unavailable with other types.

Most federal loans do not require a credit check either so if you are a student who is just starting out (or a parent with poor credit) they may be the best place to start. You apply for Federal loans by filling out the Free Application for Federal Student Aid form.

Federal Loans – Repayment

Federal loans offer a bit more flexibility to lenders when it comes time to pay them back.  This can be very beneficial but it can also allow people to remain in debt for longer than they need to. The following repayment options exist for different types of federal loans:

  • Standard repayment (Fixed payment – 10 years)
  • Graduated repayment (Payments increase gradually so paid off in 10 years; 30 for consolidated loans)
  • Extended repayment (Fixed or Graduated – 25 years)
  • Income driven repayment (20-25 years)
  • Pay as You Earn/Revised Pay as You Earn – (10% discretionary of income – 20-25 years)
  • Income Based Repayment (10-15% of discretionary income based on income and family size – 20-25 years)
  • Income Contingent Repayment (~20% of discretionary income based on income, family size and amount of direct loans – 25 years)

Fast or Slow?

While it may seem like the longer the repayment option the better that is simply not true.  The lower the payment you make the longer you will be in debt.  It may seem nice to have extra money to pay for other things but you will be treading water for decades.  You might be paying interest only for years and making very little (if ANY) progress paying them off.  That feels awful when you look back after a decade of paying the bills.  I did the standard repayment plan when I graduated.  A few of those 10 years were rough but I am not dealing with student loan debt anymore.  

The extended and income based repayment programs are best if you aren’t making much money.  This may be when you graduate and are just entering the workforce.   If you end up leaving school with a good job or get a better job after a few years choose a more aggressive payment plan that allows you to pay down interest and principal right away. 

Federal loans also offer other benefits that private loans do not.  If you are unable to pay your loans back once they have already started you can apply for loan forbearance or deferment.  Both allow you to temporarily put your loans on hold.  With forbearance you are responsible for paying the interest that accrues during that time.  With deferment you may not have to pay that interest depending on the type of loan.  Either will help you avoid default, and that is a good thing.

Federal Loan – Forgiveness

Some federal loans can be forgiven either after a long period of time or qualifying public service employment.  Several careers fall into the public service category so if you think this may apply to you it is worth verifying.  It is also something you will want to understand very well by the time you graduate.  They don’t make it easy to apply for this and there are a lot of rules that you need to follow starting with your first payment.  If you consolidate into a private loan any “forgiveness” program is off the table.

If you apply for forgiveness you might not be off the hook just yet.  With extended/income based forgiveness programs the amount of debt that is “forgiven” will be considered taxable income.  You need to prepare to pay that bill!

Private Loans

Private student loans are similar to most other loans you may be familiar with already.  They are offered by private lenders, banks and other institutions.  The interest rates they offer are different for each borrower since they are based on their individual credit history and score.  They can be fixed or variable as well.  They make the rules regarding when you need to start paying the loans back but most do offer a grace period (6 months after graduation) similar to federal loans.

Private student loans don’t have the same built in rights and protections federal ones do.  Usually there are fewer and less favorable repayment options.  Consolidation options are severely limited, so you may be stuck paying multiple private loan lenders

If you already graduated and don’t know whether your student loans are federal or private? The National Student Loan Data System is a database that lists all your federal student loans. If you have a student loan that is not listed on the database, it is probably private.

Paying Student Loans

There isn’t a general rule but I would start by knowing exactly what type of loans you have, what the interest rate is and if it would ever be eligible for forgiveness depending on your job.  Remember all loan forgiveness programs depend on legislation.  Some loans that are in repayment might be grandfathered if laws change. However, new ones might not be eligible if it goes away so be sure to know the current laws if are thinking of going back to school to change professions in the future.

Consider paying off private loans off first.  If you lose your job or become disabled there are fewer options for you like forgiveness, forbearance or deferment.  In most cases filing for bankruptcy will not cancel your student loan debt no matter what type you have.  If you are a student and something happened to you the federal loans would likely be forgiven and a private loan (no cosigner) would be paid out of your estate. 

A cosigned loan is always a private.  A loan with a cosigner would not go away if something happened to the borrower.  Your family would be on the hook to make those payments as if you were still alive.  If you have cosigned loans consider even a small life policy to cover that balance.   

After that I would debt avalanche (highest interest payment first – roll that payment to the next when completed) because it will save you the most money.  When you default on federal student loans, the consequences can be severe because the federal government has powerful collection “tools” available to get you to pay.  There is no statute of limitations, they can garnish wages, take your tax return and go after you until you die.  Make no mistake, student loan debt is serious business.  Understanding everything you can right from the beginning can help you. 

One of the biggest financial decisions you make in your life might also be the first.  Knowing the difference between the types of loans available and only taking the minimum you need will help you start off on the right foot.  Any other student loan features you would like me to dig in to?  Let me know in the comments!

 

 

 

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