Dear Carrie, I’ve tried to save for my daughter’s college, but have fallen far short. We’re considering student loans, but I worry about having her get in over her head. Are loans a good idea? –A Reader
Dear Reader, I wish more potential borrowers would ask this question before signing up for a student loan. While student loans are a necessary fact of life for most college students (almost two-thirds borrowed money for college in 2013, according to a study by the Joint Economic Committee of the U.S. Congress), they can also lead to a great deal of financial trouble later on if not handled wisely.
Because they’re relatively easy to apply for with the Free Application for Federal Student Aid (FAFSA), many student borrowers don’t realize the very real responsibility they have to pay these loans back in a timely fashion — or the equally real repercussions that can go on for years if they don’t.
There’s a lot to consider before either of you takes on this added burden — as well as a lot to discuss about repayment realities if you do.
What to think about before taking on a student loan
Just because your daughter may qualify for a loan doesn’t mean it’s necessarily the right — or the only — solution for her. Start by doing some homework together.
Figure out a realistic loan amount. First, look at the alternatives to a loan. What will your savings cover? Can she work part-time? Has she applied for all possible grants or scholarships? Plan to borrow the minimum she can get by on, because the real question is how much she’ll be able to afford to pay back once she graduates. Not every degree leads to a lucrative career, and not all schools offer the same “bang for the buck.” Have her do some research on tuition costs and on average salaries in her field of study. A good rule of thumb is to limit the debt to the amount she can reasonably earn in her first year of work.
Discuss federal vs. private loans. While both are options, start by looking into federal loans. Interest rates are generally lower and repayment options more flexible.
Decide who will take out the loan. This can be tricky. If the loans are solely in your daughter’s name, she’s the one who is legally responsible for repaying them. You could, of course, offer to help. You could also co-sign the loans. However, if you do, you’re equally responsible for repayment, and a default would affect your own credit rating. There are also federal Parent Plus Loans that allow parents to borrow, although at a higher interest rate than federal student loans.
Understand the terms of the loan. Loans vary. Compare basic interest rates and how interest accrues, as well as repayment requirements, grace periods (time before you have to start repaying), and debt forgiveness programs.
Check out websites such as finaid.org and studentaid.ed.gov for more specific information on types of loans. Then talk to the financial aid office at the school your daughter hopes to attend. Be sure to involve your daughter every step of the way. Learning how to approach debt responsibly is an important part of her financial education.
Repayment realities to keep top of mind
Even the most responsible borrowers can find themselves in a bind if their post-college employment plans don’t work out. A recent report by the Consumer Financial Protection Bureau found that over 7 million borrowers are in default on student loans. Here are some things your daughter can do to make sure she doesn’t join this group:
Stay on top of the loans. Keep all loan documents organized so that she always knows the amount owed, interest rate, term of the loan, minimum monthly payment and the repayment start date.
Explore repayment options. Federal loans have more repayment alternatives than private loans, including graduated repayments, income-based repayments and public service loan forgiveness. Figure out which is the best choice before payments are due. Consider consolidating loans to possibly lower interest rates and monthly payments.
Never miss a payment. At least pay the minimum on each loan every month. A default can lead to some even bigger financial worries, including high penalties, growing debt, garnishment of wages and a dismal credit rating that can take years to repair.
The main thing to remember is that, while student loans can be a wonderful tool for opening up future opportunities, they must be repaid whether or not those opportunities become high-paying realities. You and your daughter should carefully evaluate the possible problems, as well as her career potential before either of you signs up.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of the forthcoming book, The Charles Schwab Guide to Finances After Fifty, available from Random House Crown Business in April 2014. You can e-mail Carrie at email@example.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice.