Do your homework on student loans.

By Lauren Phillips
July 30, 2020
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Loans help people afford college, buy cars, and purchase homes or property. They’re a necessary fact of life, but they’re also an easy path into extreme debt when poorly managed. Practicing financial wellness means understanding the differences between good debt and bad debt, acknowledging that debt isn’t always a bad thing, and learning to make debt manageable and helpful, not a burden. Unfortunately, one of the most burdensome forms of debt is student loans.

Student loans are the money a student (or a student’s family) borrows in order to pay for higher education, whether technical school, community college, or a four-year college or university. They are most often used for tuition, but also help pay for room and board, textbooks, and more expenses associated with attendance.

According to CollegeBoard’s 2019 Trends in College Pricing report, the average total tuition, fee, room, and board charges for public, four-year colleges for the 2019-2020 academic year was $21,950; the average total charges for private, nonprofit four-year institutions was $49,870. With a four-year college education costing between $87,000 and nearly $200,000, depending on where you go, it’s no surprise that the majority of people are unable to pay for college out of pocket.

According to the Federal Reserve, U.S. borrowers have a collective $1.6 trillion in student debt; it can take decades to pay back these loans thanks to interest accumulation. Student debt doesn’t have to be bad—it did make it possible to achieve a college education, after all, and in many cases a college degree increases lifetime earning power drastically—but it can feel unmanageable, especially when you consider that these tens or hundreds of thousands of dollars are borrowed by teenagers.

Because many student loan borrowers are 17 or 18 years old, preparing to head off to college, they don’t always know what they might qualify for, or what options they have, says Andrea Koryn Williams, CFP, CLU, ChFC, a wealth management advisor with Northwestern Mutual. The cost of repaying those loans can shape the course of their early (and even middle and late) adulthood. It’s not super helpful to those already struggling to repay their student loans, but for students or parents researching student loans, making smart choices now can make repaying those loans in the future much easier.

There’s more to making the most of student loans than just minimizing the loan amounts, though. Here are common pitfalls or details everyone should understand before they take out student loans.

“If you’re offered more money than you need, you really should only take what you need,” Williams says. It’s true for all types of loans: The number one rule for borrowing money is taking only what you need—any more, and you’re just adding to the amount you’ll have to repay later.

Student loan amounts can be high, but they are typically capped at what’s called the cost of attendance.

“The cost of attendance is an annual holistic number calculated by each school which can include everything from tuition and fees as well as room and board, books, lab fees, and other equipment like laptops,” says Lauren Anastasio, CFP at SoFi, which offers private student loans and student loan refinancing. “Most lenders will cap the amount a borrower can take each year, or semester, based on the cost of attendance of the school the borrower is enrolled in, so it’s reasonable to expect you’ll be able to borrow for other expenses, but only up to the amount the university expects those expenses will cost.”

The amount you’re able to borrow will depend on the school you attend, but there are some steps students and their families can take to reduce the total cost. Many schools require students to live on-campus for one or two years; if they’re comfortable doing so, students can opt to live off-campus in their later years of college to save money on room and board and potentially lower the amount they need to borrow.  

If a loan provider offers a larger loan than is needed, don’t think you have to take it all, and don’t take what you don’t need as a buffer: A little extra money borrowed now can mean much more to pay back later. Sometimes, your loan provider can pay too much money to your institution, in which case the financial aid office will give you a refund check, Williams says. Despite appearances, this is still part of the loan and will need to be paid back later. “It could happen every single year,” Williams says.

The best action is to not keep that money: You can contact your loan provider to return the money, decreasing your total debt, even by a small amount.

Understanding the types of student loans—and their benefits and risks—is important, says Nancy DeRusso, SVP and head of coaching at Ayco, a Goldman Sachs company that offers company-sponsored financial counseling programs, but so is taking advantage of other so-called no-cost ways of paying for college. Fellowships, grants, scholarships, and other options are out there to help make college affordable and should be used before families turn to student loans.

“Not planning early enough is also a common pitfall,” DeRusso says.

Figuring out how to pay for college through careful saving can also help. 529 plans and other college savings efforts work best over the long-term; when diligently added to, such an account can eliminate the need for student loans altogether, or at least make it possible for students to borrow less money.

One distinction many people wonder about after the fact is the difference between a subsidized loan and an unsubsidized one.

“Interest on subsidized loans is paid by the U.S. Department of Education while an undergraduate student is in school, [during] the first six months after leaving school, and during periods of deferment,” says Lauren Wybar, CFP, a senior financial advisor with Vanguard Personal Advisor Services. “Unsubsidized loans are available for both undergraduates and graduate students. Interest always accrues, including while the student is in school and during deferment.”

Subsidized loans don’t start accumulating interest for the borrower immediately, because the federal government is subsidizing the loan by paying that interest during prescribed periods of time; unsubsidized loans accumulate interest that the borrower will eventually need to pay back from the moment they’re taken out.

While subsidized loans come with benefits that unsubsidized ones lack, picking subsidized loans is “not really a decision you get to make,” Williams says. “It’s made based on need, and there’s very little control that you have when you’re applying when you initially obtain these loans.”

Eligibility for a subsidized federal loan is determined based on the student’s tuition cost and family income, Wybar says, which are reported through the Free Application for Federal Student Aid, or FAFSA. Some families may believe they won’t qualify for a subsidized federal loan and skip filling out the FAFSA, but that could prevent them from accessing unsubsidized federal loans, which are federally guaranteed (like subsidized federal loans) but begin accruing interest as soon as the loan is disbursed. Both types of federal student aid—subsidized and unsubsidized—may have forbearance protections or other benefits that help borrowers, as during the coronavirus crisis, when certain federal student loans were set temporarily at 0 percent interest and all borrowers were placed on forbearance, which suspended the need to make monthly payments for a few months.

Some loans are specifically designed for parents to borrow to pay for their child’s (or children’s) education. They may or may not qualify as student loans, have immediate or delayed repayment schedules, or allow for ownership of the debt to be transferred to the student after graduation, Anastasio says. The terms will vary by the loan and the lender, but parents need to understand exactly what they’re signing up for, she says.

“Will they be a co-signer or sole owner of the debt? What happens to the debt in the event of default or death? Is the loan eligible for federal benefits like income-based repayment plans, deferment, or Public Service Loan Forgiveness? Will the loan qualify as a student loan for tax purposes? It’s vital to do your research before borrowing to understand exactly what type of loan you will have and how it should be handled during repayment,” Anastasio says.

If parents are unable or unwilling to borrow the money themselves, they may still need to co-sign on a loan with their student. Applying for a student loan will likely involve a credit check, Anastasio says, and many incoming freshmen—17- and 18-year-olds, often—don’t have a substantial credit history. (Fortunately, student debt that is repaid on-time can help people build their credit histories.) Student loan lenders are aware of this and adjust their standards accordingly, she says, but it’s still common for a student to need a parent or other family member to co-sign on a loan. Parents or guardians should be aware of the implications of that for them.

Federal loans—subsidized or unsubsidized—and many private student loans come with grace periods, usually six months and sometimes up to 12, that give graduates time to get settled before they must begin making payments.

“In most cases interest will still accrue during this time, so if a graduate can afford to begin making payments before the grace period is over, they may be inclined to do so,” Anastasio says.

It’s important to understand the terms of that grace period: If a student takes a gap year between their second and third years of school, for example, they could use up the grace period and the repayment schedule could begin. (In most cases, it would go back into deference once the student re-enrolled.)

Another, less common, course of action is to make payments on loans while still in school, particularly on unsubsidized loans, which accrue interest even while the student is enrolled.

“Most student loans tend to come at low interest rates, so while making payments in school can modestly decrease the total amount you will have to repay, there are usually better uses for the money than making voluntary prepayments,” Anastasio says. Namely, a student could save the money for a cash cushion to use as they settle into post-college life or not work at all (or work fewer hours) in order to focus on studying.

“If a borrower can afford to make the payments without sacrifice, it will save money in the long run, but each student needs to decide if that makes sense for them,” Anastasio says.

When someone borrows a student loan, that loan is given a set interest rate that determines how interest accrues for the life of the loan, until it is paid off or refinanced. Refinancing effectively gives a loan a new interest rate and can even be used to consolidate multiple loans: In refinancing, you take out a new loan (often with a different provider and ideally at a lower interest rate) to replace existing debt, so if someone has many loans, they can be grouped into a single payment.

“Borrowers often have multiple loans, even if they only work with one provider,” Anastasio says. “Typically loans are issued per semester, so it’s not uncommon for a student to graduate with 8, 16, or even 20-plus different loans.”

Consolidating loans certainly simplifies the repayment process, but timed right, it can also lower the total payment amount. Interest rates fluctuate, so if a student loan borrower were to refinance when rates are lower than they were when the loans were taken out—or if the borrower raised their credit score or increased income, which could lead to approval at a lower interest rate—they would lower the amount of interest accrued by the loan and have to pay less over time.

Students can refinance once they graduate college, but refinancing immediately might not always be the best step, even if rates are low: DeRusso says refinancing federal student loans too soon after graduation could mean losing any benefits associated with federal loans, including federal forbearance protections during times of crisis.

For those interested in refinancing, when timed right, it’s a fairly certain way to reduce debt burden, even in the long-term. Best of all, it shouldn’t have costs or fees associated with the process, Anastasio says: Services such as SoFi offer no-fee loans.

“Since there’s no cost, a borrower should consider refinancing anytime they’re eligible for a loan that can save them money,” she says. “Some borrowers refinance to lower their interest rate, others to lower their monthly payment, and some lucky borrowers get to lower both. Whenever you’re able to refinance onto a more attractive loan you should pursue it. There’s no cost, so there’s no reason not to save money.”