This article, written by Joshua Cohen, originally appeared in the May/June 2020 issue of GPSolo magazine, volume 37, number 3, published by the American Bar Association Solo, Small Firm and General Practice Division. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Membership in the Solo, Small Firm and General Practice Division is now complimentary. Join now.
Student loan borrowing has outpaced all consumer borrowing except home mortgages, yet students and their parents are given little guidance on how to borrow responsibly. This article will discuss common pitfalls of student loan borrowing, provide an overview of student loan programs, and share a strategy for borrowing responsibly.
In the world of consumer borrowing, nothing is more misunderstood than student loans. While most students and parents expect to borrow, not all take the time to understand how the loan industry operates. And those who do take the time to research the subject are often left more confused as they dig deeper. Resources are one-sided, making them hard to trust. Should borrowers trust the financial aid department at the universities or lenders that are constantly in the press? Or how about the US Department of Education (USDE)?
Then there’s the jargon: federal loans, grants, private loans, capitalization, cost of attendance, and on and on. There is very little about the student loan system that is intuitive. In fact, I’ve found that the more financially savvy a person is, the less the student loan industry makes sense. The reason is obvious. The USDE is in the business of education, not finance. So why, then, is the USDE charged with funding and controlling federal loans? As a humble consumer law attorney, I leave that question to economists and financial experts, of which I’m neither.
The biggest pitfall is the belief that borrowers will have the ability to pay back their loans. Regardless of the type of student loan, paying it back is tricky. There are two reasons for this.
- The rules that govern student loans, specifically federal student loans, allow for capitalization of loan interest during times when folks can least afford it. In other words, the rules punish those who can’t afford their loans by making the loan balance even more difficult to pay.
- Discharging student loans in bankruptcy is extremely difficult, making them nearly impossible to escape when the chips are down. Comparing student loans to mortgages is unfair. Mortgages often have better interest rates and have an escape route through bankruptcy if everything fails. There are very few consumer debts that are inescapable through bankruptcy. Even taxes can be discharged in a bankruptcy.
Aside from the inability to pay back the loan, the second biggest pitfall is pride. School pride. I admit I’m proud of the university I attended. And I was proud when people in town found out where I was going because they knew it was a challenge to gain admission. This was the early 1990s when the price of college was not yet as serious of an issue. The lack of ability to pay back student loans was just a blip on the financial radar. Today, however, things are different. The problem has gotten to the point that student loans have become a platform for many political candidates.
As my law practice focuses on clients caught in the student debt trap, I can attest that very few college-bound students—or their parents—saw this trap coming. They didn’t believe pitfall number one (the false belief that student loans would be affordable), and they didn’t understand pitfall number two (the role of school pride).
I’m going to do this backward and discuss the second pitfall first: school pride. What I’m really talking about here is the price tag—specifically, the cost of attendance (COA). According to the USDE:
The COA includes tuition and fees; on-campus room and board (or a housing and food allowance for off-campus students); and allowances for books, supplies, transportation, loan fees, and, if applicable, dependent care. It can also include other expenses like an allowance for the rental or purchase of a personal computer, costs related to a disability, or costs for eligible study-abroad programs.
Student aid is based on COA. It’s the budget to attend college. Notice that it’s not just tuition. It’s everything. When looking at school, don’t look at tuition cost, look at COA. That is where the student loan number comes from. Of course, you’re not going to borrow the whole COA. Students are awarded a student aid package that consists of grants and scholarships and loans.
Grants and scholarships are not loans. They are not paid back, which is why students and parents should seek out scholarship opportunities before signing any loan paperwork. The availability of scholarships is amazing. There are scholarships for almost any reason, including class rank, hobbies, instruments, and sports. Boy and Girl Scouts have college scholarships. There are dance scholarships, sewing scholarships, even gaming scholarships. In the age of Google and self-research, it’s not hard to find a scholarship for college. Think outside the box. You may be pleasantly surprised.
After grants and scholarships have been used up, there may be a gap left. The two options to fill it are out-of-pocket payments or loans. A combination of both is likely the result. But what kind of loan? I’ll get to that in a minute.
The reason I talk of school pride is because many folks refuse to see the opportunity, or savings, of a community or local college. Instead, many get stuck on the name. Don’t get me wrong. There are some schools whose name will open doors more easily for graduate school or employment opportunities. However, graduate school is even more expensive than undergraduate, and it’s not as easy to shop by price tag. The one place where students can be frugal and still achieve their goals is college.
Yes, college is a time of opportunity—to travel, to be independent, to learn how to be an adult. However, due to soaring costs, price should play a part in the decision-making process. There are quite a few states that now have free or significantly discounted community college. Also, many state schools are cheaper for in-state residents. While I agree freshman year is a great time to try different career paths and explore, doing so at a private university with an $80,000-a-year COA may not make any sense when the same opportunity can be experienced for a fraction of the price through a state school or community college.
Student loan affordability assumption
Now, back to the first pitfall: the assumption that students will be able to pay back their student loans upon graduation and landing a job. Many careers require degrees with costs that don’t match up to earning potential. Social workers require a master’s degree. That means a loan balance on average of $150,000. Yet few social workers I know earn more than $50,000 a year. Teachers, depending on the state, may also require a master’s degree, yet the starting salary is often between $30,000 and $50,000 a year.
You should consider a combination of factors here. What degree is the student pursuing, what will she do with it, and what is the earning potential? Bottom line: Students and parents need to do much more research about career potential. And please, be honest with each other. There was a time when going to college to find oneself was a good idea. I’m not so sure that’s the case anymore. Not when a child and/or parent could rack up high five-digit debt. The pressure on the student is unbearable. We see this all the time. I’ll discuss specific bad situations later in the article. First, let me explain the different types of student loans to help you better understand how the odds are stacked against borrowers.
There are two kinds of loans: federal and private.
Federal loans are those borrowed from the USDE. There was a time when federal loans could be obtained from private banks, but that ended in 2010. There was also a time when schools could lend money under the Perkins Loan Program, but that ended in 2017. Federal funding is getting more difficult to obtain, while costs are still growing.
There are two federal loans worth discussing: Stafford loans and PLUS loans.
Stafford loans come in subsidized and unsubsidized amounts. Subsidized amounts are based on need as determined by the college. The government pays the interest on subsidized loans during periods of deferment, such as in-school deferment. Subsidized loans are only available for undergraduate Stafford loans. Unsubsidized loans are not need-based. The borrower is responsible for interest at all times, even during deferments.
The amount available for Stafford loans is capped by the student’s year of study. The first-year maximum is $5,500. The second-year maximum is $6,500. The third and subsequent undergraduate years are capped at $7,500 per year, with a maximum aggregate of $31,000 for undergraduate Stafford loans. These amounts assume the student is a dependent. Undergraduate Stafford loan limits increase to an aggregate of $57,500 for independent students. For graduate programs, the yearly maximum is $20,500 with an aggregate limit of $138,500.
PLUS loans are another federal loan available; however, they work differently. The amount is capped only by the COA, not the year of study. Let’s say the COA is $50,000 but the student’s aid package of grants, scholarships, and Stafford loans covers only $20,000. There’s a $30,000 shortfall. Whatever the student and parents can’t afford out-of-pocket can be covered by a PLUS loan. If they need the full amount, they can take a $30,000 PLUS loan. Now, read the following carefully.
Undergraduate students cannot have a PLUS loan. However, their parents can. It’s called a Parent PLUS loan. It’s in the parent’s name. The student is never responsible for the loan. That means, using the above example, if the family needs an additional $30,000 for the child to attend college, the parent is on the hook for $30,000. And that’s just one year! Multiply that by four years, and the parent stands to owe $120,000. That’s right! The parents aren’t going to college, but it costs them more than the child. And regardless of what happens with the students—if they don’t graduate, if they graduate and never speak to their parents again—the parents are still responsible for the entire Parent PLUS loan balance. Ouch!
For graduate school, however, it is the student who takes the loan. These are called Graduate PLUS loans, for graduate students only.
What makes federal loans better than private loans (discussed below) are the repayment options. Everyone understands how loans normally work. There is a definite payment period over which the loan is paid in full. Federal loans offer 10- and 25-year terms. That means over the course of 10 or 25 years, interest will accrue but the loan will be satisfied within that term. It’s no different than any other consumer loan. Unfortunately, many borrowers cannot afford this payment. In the example above, the parent is stuck with $120,000 in Parent PLUS. Or consider a graduate student who now has $27,000 in undergraduate Stafford loans, $41,000 in graduate Stafford loans, and an additional $52,000 in Graduate PLUS loans for a total of $120,000. The 25-year payment on these loans (assuming a 5 percent interest rate) is $700 a month. This may not be affordable when the graduate’s income is $50,000 a year.
With federal loans, there are additional repayment options based on the borrower’s income and family size. These options are called income-driven repayment (IDR). For the Parent PLUS borrower making $50,000 a year as a family of two, the payment could decrease to $500 a month. For the graduate student borrower earning $50,000 a year as a family of two, the payment could drop to $200 a month. Further, with IDR, whatever part of the balance is not paid within 20 to 25 years is forgiven. It might be taxable, but that’s still a smaller amount than the forgiven loan balance. Also, federal loans can be forgiven after just 10 years of payments if the borrower works for a government entity (federal, state, county, township, etc.) or a 501(c)(3) nonprofit or many public service not-for-profits. Remember that social worker earning $50,000 but owing $150,000? Ten years of work and payments and the balance is forgiven.
Another benefit of federal loans is that they can be rescued if anything goes wrong. It takes nine missed payments to default. But if a default occurs, it is possible to get the loan back into good standing. That’s very important because there are very serious consequences when a federal loan defaults, including:
- administrative wage garnishment (no lawsuit required)
- Social Security offset
- federal tax refund intercept
- collection calls and fees up to 25 percent of the balance
Although the collection powers are draconian, the ability to rescue a defaulted federal loan makes these loans safer than private loans.
Ultimately, federal loans are advantageous because (1) they should always be affordable, (2) they may qualify for forgiveness depending on the borrower’s employer, and (3) they can be rescued if something goes wrong.
Private loans are those borrowed from any entity other than the USDE. It could be from a bank or credit union or a state agency. Private loans are like any other consumer loan product from these entities with the exception that they often cannot be discharged in a bankruptcy.
A co-signer is often required to obtain a loan, especially when it’s for an 18-year-old undergraduate student with no job or credit history. These loans have two payment options: pay or don’t pay. Whatever the term is, that’s the payment for the life of the loan. Many lenders will offer 24 to 36 months of forbearance. After that, too bad. The loan defaults after one missed payment and charges-off (i.e., can no longer be rescued) after four to six missed payments. Prior to the charge-off, a loan can be rescued by simply making the missed payments. Once a loan is charged-off, it is in default forever. At that point, the lender can hire a debt collector. Eventually, the lender may sue the borrower and/or co-signer. The creditor can undertake whatever remedies are allowed under state law if it wins a judgment. Is this risk worth a brand-name school with a brand-name price tag? Only you can answer that question.
State agency loans are even worse than bank loans. Not only can the agency do everything just mentioned, but often it has additional collection powers such as state tax refund intercepts for the life of the loan (or borrower and co-signer). While some states have mechanisms to rescue a defaulted loan, they aren’t always affordable.
Food for thought
When you are considering a student loan, take the time for comparison shopping and running the numbers. And take a hard look at the odds. Private loans may have better interest rates (not always), but they often require a co-signer and have no flexible payment options. Federal loans have harsher collection powers but have friendly payment options. Also, forgiveness based on employer may be available.
Then there’s the last factor, which simply can’t be predicted: life. Marriage, divorce, children, medical issues, etc. Life happens. Financial woes can occur in a split second, making student loans not just unaffordable, but the last thing you’re worried about. But the loan is still due—or is it? Federal loans also come with disability discharge and death discharge. Private loans often do not, and creditors could chase an estate if they wish.
The best piece of advice when it comes to student loans is simple: Don’t take any. But if that’s not possible, federal is better than private. In the world of private, a bank is better than a state agency. If you’re a shrewd shopper, dependency on student loans can be minimized and managed. That is how you win the game.