Student Loans: The Good, The Bad, and The Ugly
Are student loans good for your financial health? They are certainly in the news a lot and often not in a good way. But loans are an important financial tool for financing a college education and can be all three: Good, Bad, and Ugly.
Good Debt and Bad Debt
First of all I want to explain my view of debt. There is good debt and there is bad debt. Good debt is any debt which you take out to pay for an asset which has a good likelihood to appreciate in value. If you live in your home for 10 years or more, then it has a pretty good chance to appreciate in value so a mortgage is good debt. Bad debt is any debt you take out to pay for assets which depreciate in value or maybe have no value at all. Credit card debt used for clothing purchases is a perfect example of bad debt. What do you think used clothing is worth? As soon as you walk out of the store and put it on, its worth pretty much nothing. Many people borrow to pay for their cars and even though sometimes you have to get an auto loan because you don’t have $30,000 lying around, it is also bad debt. Cars depreciate incredibly fast when you leave the showroom and debt used to buy them is definitely bad debt.
So how about a college education? A college education is an investment in the student. If you think about a student’s worth as the present value of his/her lifetime of income, that income will be worth more with a college education. So you are investing in an appreciating asset and from that point of view, a student loan is good debt.
What Can Make a Student Loan Ugly?
So a student loan is good debt, right? Well yes, but it can still be ugly. When you take out a mortgage on your house, the lender checks to make sure you can pay the loan back. They check your credit score and your income to make sure you can afford the loan. The loan is secured by your home, so if you don’t pay the bank takes your home and you don’t owe anything anymore. The problem with student loans is that students have no credit score, no current income, and nothing to give the bank to secure the loan. And in the case of private student loans, there are no limits to the size of the loans. There is no guarantee that the student will graduate and get a job with sufficient income to pay back the loans. This is what can make student loans ugly.
There are also some other rules for some student loans that can make them ugly. The fact that student loans are rarely discharged in bankruptcy. Also, some student loans don’t get discharged even when the student dies. And of course, students owe the money whether or not they finished school and got a well-paying job. Ugly Ugly Ugly!
But student loans don’t have to be ugly. If the student borrows just a little bit, finishes school, and gets a good job, a student loan can be good. Unlike with mortgages, it is up to the borrower to make sure student loans are good and not ugly.
Types of Student Loans
There are several types of student loans, but there are three basic categories:
- Federal Student Loans
- Private Student Loans
- State Student Loans
Federal Student Loans
Federal student loans are the best kind of student loans. They are the first kind the student should look into because they have lots of good features:
- Generally lower fixed interest rates
- Good income-based repayment plans which have some allowance for loan forgiveness
- Limits to how much loan you can take
- No co-signing necessary
Federal Student Loans become available through the school once the student fills out and submits the FAFSA. They can be either subsidized or unsubsidized, but both have the same interest rate for undergraduate studies: 3.76% for the 2016-17 school year. Parents can also take out Federal Direct Plus loans for their students, but it is less clear that this is a good deal. More detailed information can be found here and here.
Private Student Loans
There are a lot of problems with private student loans. They can become ugly pretty fast because they do not have great repayment plans, require parent cosigning and either come with higher interest rates or floating rates. There are also no limits to the amount or number of loans you can take, so its very easy to become over-extended. In most cases, if you take out private student loans, you should be questioning the student’s entire education plan. Maybe there is a way to get the education you want at a cheaper institution.
If you are still interested in private student loans, there is a good information and comparison website here.
State Student Loans
Some states have their own student loan programs. I am not familiar with all these programs, but after reading this story which appeared in the New York Times and ProPublica, I say beware: https://www.propublica.org/article/new-jerseys-student-loan-program-is-state-sanctioned-loan-sharking. This article is about New Jersey’s program, but you should thoroughly vet the program in your state before signing up for a state student loan.
Ways of Making Ugly Loans Slightly Less Ugly
So you decided that one of the uglier student loans was the best option. There may be a couple of ways to make the loans slightly less ugly.
Term Life Insurance
This is a great idea for a student loan which the parent is a cosigner and even a good idea for a parent loan. It is the worst possible outcome if a student can’t finish his or her education because of death. Not only does the parent lose their child, but the loan is still owed and the parent will have to pay for a college education for a dead student. If the student is young and in good health, a term life insurance policy for the amount of the loans will be very cheap. Probably only a couple hundred dollars a year at the most. The insurance policy can pay off the loan in case of student death. It would have probably been the right answer for the situation in NJ described above.
Remove the Co-Signer
For many private student loans, the co-signer can be removed after about a year’s worth of loan payments. They don’t tell you that you can request this, but is an excellent idea. Now if the student dies, the parent will be off the hook.
Evaluate the Income Stream
When I was in undergraduate college, my parents made me take out student loans. My dad had saved money for my college and he paid most of it, but he wanted to make sure I had skin in the game. I studied engineering and after college I got a well-paid job which allowed me to repay the loans in 5 years instead of the normal 10. But what if I was studying a different subject where the income prospects were not as good? Parents and students need to carefully evaluate the income stream before committing to student loans as a payment method for college. Borrowing for a top student committed to a well-paid degree is very different than borrowing so a mediocre student can find themselves. Let them find themselves at community college, not at NYU.
You can find more information on college planning in the learning center on my website.
And feel free to reach out to me with any questions.