Benefits and Pitfalls of Student Loans

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The Savvy Student's Guide to College Education—Chapter Seven

The Big Picture

Students thinking about taking out loans to pay for college usually fall into one of two categories. Either they are more than willing to take out any amount they need, or they are too terrified of not being able to pay back the loan to even think about taking one out. The best way to consider if a student loan is right for you is to get an understanding of the purpose of loans in general, and understand how they work. From there, students should consider the reasons why a student loan would create a stronger college choice for them—or, in some cases, create a college choice. It's then important to understand how the unexpected can make it more challenging to pay back student loans, which can affect a student's credit history, and their ability to provide for themselves and their family as an adult. In the end, four key questions should drive the decision to borrow for college, and how much to borrow for college, remembering that money is a factor in making a good college choice, but not the only factor.

It's almost impossible to think about going to college without thinking about student loans. In a way, that's a very good thing, since a loan of any kind has an impact on our lives for many, many years, and it's important not to do anything that has a long-lasting effect on our lives without thinking about it for a while.

At the same time, it would be pretty easy to listen to older friends in college and some family members and think that you should never take out student loans, no matter what. People often give that advice because they want to make sure you don't end up owing more in student loans than you can afford to pay back, especially if you don't finish college with a certificate or a degree that helps you get a good-paying job. But automatically saying “no” to a student loan is almost as bad as automatically saying “yes” to a student loan. Without considering the advantages that come with a student loan, as well as the commitment you're making when taking one out, you're really just guessing about your future—and that's just as bad as picking a college without visiting the campus.

Like any other part of the college selection process, deciding whether or not to take a student loan requires information and research, so let's take a look at the world of student loans, and see what might make you decide it's worth doing to meet your life goals, or something you're better off living without.

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What is a Loan?

Most high school students have only heard about the loans their parents have taken out, to buy things like cars or houses, or to start a business. These are great examples of why people borrow money—to get something right away that they are willing to pay extra for once they get it. Most loans are given for big purchases—like houses—where it would take a very long time to save all the money needed to pay for something in cash. Instead of doing that, the purchaser decides to borrow some of the money they need to buy the house (or car), and pays the loan back in small amounts over a large period of time. Some of each payment goes towards paying off the loan, and some of each payment is interest, or extra money the lender gets for loaning you the money to begin with.

The interest part of a loan can easily be seen as a reason not to borrow money, since paying interest increases the cost of whatever you're buying. Let's say you want to borrow $25,000 to buy a new car at an interest rate of just over 3%. You would get the car right away, and each month for the next 5 years, you would pay $450 a month to pay off that loan. At the end of that time, the car is yours to keep, sell, or do whatever you'd like with, and you would have paid $27.026 to pay the loan back—so the car would cost you an extra $2,026.

Since it doesn't make sense to pay more for something if you can get it for a lower price, some people wonder why someone would take out a loan to pay for anything. In this case, it's likely the person taking out the car loan doesn't have $25,000 in cash, and they either need—or want—the car right away. If they have a job where they make enough money that the lender believes they can afford the monthly payment, it's much easier for some people to repay $450 a month at a time to a lender than it is for them to put $450 in a savings account each month for 56 months. With that much money, they might decide to spend it on other things, like a vacation, and never have enough money to buy a car in cash. This is especially true if someone is buying a house. With the average price of a house at about $185,000, it would take someone over 34 years to save $450 a month to buy that house in cash.

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Benefits of Student Loans

The basic ideas of a loan make a great deal of sense when you think you need money for college. There aren't many brand new high school graduates who have $24,000 in cash to pay for the average year of college by themselves (that includes tuition, room and board, and books and fees—see here), and many families find it hard to save for college while paying for food, cars, housing, and medical care, especially when the US economy was doing so badly for many years. This is one of the reasons why 7 out of 10 students recently graduating from college had $28,000 in debt that came from taking out student loans (see here).

What would lead someone to decide to take out that much money for college? It can be any one of these reasons:

It prepared them for a better-paying job

It surprises many students, but one of the best ways to make more money is to borrow money for college. The Bureau of Labor Statistics (BLS) shows that the average four-year college graduate makes nearly twice the monthly salary of someone who only has a high school diploma. Even when compared to students who take some college classes but don't earn a degree, four-year college graduates make nearly twice as much in salary—and their unemployment rate is a little more than half, meaning they are much more likely to be employed.

It allowed them to have a longer college experience

Some families are able to save enough for a student to attend one or two years of school, but if their child is looking for a four-year college experience, a student loan can make all the difference. Those two extra years of school can also make a difference once the student graduates, since four-year degree holders make about 40 percent more than graduates with a two-year degree.

It let them live away from home

Most people are surprised to discover that the average cost of college tuition is about $9,500. That's still a lot of money, but it's much less than the average $24,000 that includes room and board. This means that a student living at home during their four years of college can save a lot of money, even when adding in books and the cost of keeping up a car to drive back and forth to school.

Living at home during college has many advantages, but for some students, living on their own is part of the college experience that's very important to them. In addition to being able to sleep in (when they don't have class) and stay up late, living away from home gives students the opportunity to interact with roommates from different towns, states, or countries. It also gives the student the chance to learn how to manage time between school, social activities, and life activities like doing laundry, shopping for food, and managing their own budget. For many students—and for some parents—living away from home while going to college is just as meaningful, and as much of an education, as the classes the students takes. For families who feel that way, taking out student loans to pay for this important experience is an easy decision to make.

It gave them a different college experience

Students who are admitted to more than one college are in the challenging position of comparing what each college has to offer, and deciding which one is a best “fit”, or the one that best meets all of their needs and interests. In deciding among different colleges, cost isn't the only factor, but it certainly is one factor many students consider. The average cost of attending college may be $24,000, but that means there are many colleges that cost much more than that. If a student is admitted to two colleges, and one costs much more than the other, is it really worth the difference—even if that means taking out loans to attend the more expensive school?

For some students, the answer is yes. The more expensive school may have a better reputation for the program the student wants to study, and that could lead to better job prospects after graduation, or a richer learning experience during college. When comparing factors like the number of internships each college offers, or where those internships are offered, students often feel the quality of the more expensive college is worth taking out loans to afford.

Many students looking at a difference in price between two schools are looking at a public college that's less expensive, and a private college that has a smaller class size, but a higher price tag. In this case, some students feel the private college is a must, since they are more successful students when they are in classes with fewer students. In this case, student loans may make an important difference in their college choice. At the same time, these students will also want to look into the residential or honors college options at their public universities, since these programs often have smaller class sizes available to students who qualify for these advanced programs. These specialized opportunities may also have special scholarships available for qualified students, giving the student additional financial support for college that doesn't have to be paid back.

Finally, other students may choose the smaller learning environment that's more expensive just because the school feels more comfortable to them. Feeling at home is certainly an important part of the college experience, but it isn't the only part of the decision, since too much comfort might not inspire the student to challenge themselves to go out and meet new people, or make the most of the learning experiences at college. Students should also remember that many colleges allow students to live off campus after their first or second year at college. This gives the student the chance to spend a little more on housing, while still enjoying the savings of a low tuition college. These decisions are part of the student's personal preferences, but it's important to remember that if those preferences are being funded with student loans, there are long-term consequences to the choices the student makes.

It let them go to college

There are a growing number of students who simply don't have the money and other resources they need to go to college without borrowing money to do so. For many of these students, borrowing this much money before they begin their careers can be a little scary, and that makes sense. But to them, not going to college at all seems even scarier, since college can lead to the personal and professional growth they need to understand more about the world, contribute more to the world, and make a better life for themselves and their family. This doesn't mean they should borrow money they don't need, and it doesn't mean they should automatically go to the most expensive college that admits them, but if a student loan is the difference between a well-thought out college choice and no college at all, the choice can be pretty easy to make for many students.

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Pitfalls of Student Loans

Borrowing money at any stage of your life should be a reason to think very carefully about why you're borrowing the money, and if you really need it. This is especially true if you don't really know how you're going to pay the money back. Failing to pay back a student loan (also known as defaulting) can lead to having paychecks taken away from you, a bad credit rating that will keep you from getting credit cards or other loans, and more.

Students can't always predict the future—no one can—but it is important to think about the following factors before you borrow, since your answers to many of these issues can help determine if you're going to pay back your loan:

You change your major, which leads to a different career choice

You decided to take a student loan to pay for a more expensive college experience. Since you planned on becoming an Engineer, you were pretty sure your starting salary (usually around $70,000) would give you more than enough money to pay off your student loans—in fact, you'd likely have enough money to pay it off early.

The plan was going pretty well, until you got a D in your first semester of Physics in college, and fell in love with the idea of being a teacher instead, where the starting salary is much lower. You might qualify for some loan forgiveness if you teach in high need schools for several years, but paying your bills and your loans is going to be harder on this lower salary.

Part of the college experience involves trying out new classes, and thinking about new careers. But if your college financial plan is built around a high-paying career, either the plan will limit the new classes you can consider, or the new classes could make your payment plan more difficult. Make an honest assessment of your interest in your major before you bet too much of your future on it.

You try out your career, but just don't like it

The same problem can come up once you're done with college, and you go into the field you studied in college—what happens when working as an accountant, day after day, doesn't turn out to be as interesting as it seemed when you were doing something new as an intern every week? It can be hard to look four or five years ahead and decide if you're going to like your job, but job shadowing and research can give you some clues, and if you aren't sure, don't bank your college payment plan on a big paycheck.

Your family's financial situation changed

This happened to thousands of college students during the Great Recession. Your family had saved enough for you to attend a public university, and you decided to take out student loans to attend a private college instead. Suddenly, one parent loses a job, or their investments lose a lot of value, and now you'll need to take out even more loans just to complete college at a public university—and that's if your credits will transfer. There's a difference between using student loans in an emergency, and using them to buy something you can't otherwise afford. Make sure you understand which way you're using them.

You transfer colleges

More than a few students find their first-choice college isn't everything they thought it was going to be, and it makes sense to transfer to another college if that's the case, especially if you're transferring to a less expensive college. But many transfer students find that not all of their credits will transfer from one college to another, which increases the number of semesters you'll be in college—and that increases the size of your student loans. If there isn't room in your long-term plan for more loan, your college plans are now in peril.

The terms of the loan change in ways you hadn't expected

You were so excited to finally find a bank that would be willing to give you a loan for college, so you signed the papers and headed off to campus. That month, you were surprised to receive your first payment notice for the loan. It turns out this loan didn't have a deferral option, where you could wait to start paying on the loan until you finished college. It also turns out the interest rate is much higher, since it wasn't a loan that was subsidized by the US government. The loan you wanted may have had those options, but the loan you received has none of those. You now have to go back to work to pay for a loan you took out for college—but since you didn't understand the terms of the loan, you have to quit college to pay back your college loan.

You don't finish college

Too many students who borrow money for college think they don't have to pay the money back if they don't earn a degree or certificate. They think that they can simply stop going to school if it gets too hard, and someone else will take care of the loan.

This is a hard lesson for many students to learn, but any money you borrow for school has to be paid back, whether you finish college or not. It doesn't really matter what the reason is; if the work is too hard, if you get sick, if your parents need you back home, you've still borrowed money for college, and that money has to be paid back.

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Four Questions when Borrowing for College

Some students get so excited about having the chance to make their college dreams come true, they don't pay any attention to the amount of debt they go into to make it happen. Other students read about all of the unknowns of borrowing to pay for college, and decide they shouldn't borrow a single cent for school, even if it means not going.

All students, and parents, who are considering student loans for college should let these four questions guide their decision to take out student loans for college:

Have I used up every other reasonable source to pay for college?

Everyone has a different mix of income, savings, investments, and assets, so there isn't one single way to address this question. What's important is that each family looks at the resources they have to pay for college, and the cost of the college options they have, and make as good a match as possible. This may include borrowing, and it may not, but it needs to include a discussion of factors other than affordability. If a less expensive college is a bad fit, a loan may be the right thing to do.

Are we borrowing the absolute maximum we can, or are leaving some room for an emergency?

Any family that needs to take out a loan should always leave room for the unexpected, and that's definitely the case with student loans for college. Having no resources to tend to a sudden illness or personal issue adds significant stress to the student, and that increases the chances they will do poorly in college, or drop out completely. Be sure to leave some financial wiggle room.

Would we be better off taking out loans in the parent's name?

Most student loans that have deferred payment plans and subsidized interest rates have to be taken out in the student's name, but there may be some situations where parents are better off taking out loans rather than disturbing long-standing investments. Make sure you understand all of your options before committing to a loan.

How will the student pay these loans back?

Many of the jobs of the future haven't been invented yet, making it even harder for students to create a plan for paying back student loans that is guaranteed to work. On the other hand, maxing out your student loans with the idea that you'll pay them back “someday” isn't the best approach, either. Students should research the starting salaries of at least a few careers, and run some numbers through a student loan calculator (as an example, see this one) to get some kind of understanding of the future financial commitment they're making. This exercise can also be an eye opener to students who have never thought about what it costs to pay rent, insurance, utilities and food. Seeing student loan repayment as part of a bigger picture can only help them make a stronger, more-informed college choice.

Student loan refinancing can also help when it's time to repay loans. See our "10 Best Student Loan Refinance Deals."

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More Resources

Paying for College

The current state of student debt

Unemployment rates by level of education

Student loan calculator

An overview of student loans

Managing and repaying loans

Private student loans

Is it Worth it?

Student loan success story

Student Loan Debt Regret

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