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By
Liz Pulliam Weston, ©
2007, Bankrate,
www.bankrate.com
Student loans are usually classified
as "good" debt. Like a mortgage or a business loan, borrowing for education
can be a smart investment in your future.
Too many of today's students and their parents, though, are taking a good
thing way too far.
I get e-mails from readers who are $30,000, $40,000 or more in debt from
student loans and who can't find work in their fields. Even if you graduate
with the average level of education debt - about $18,000 - you may be
jeopardizing your finances. Many newly minted graduates find their loan
payments are so big that they can't save for other goals, such as a house or
retirement.
Four years of loans can last a lifetime
Putting off these goals to pay debt is an expensive choice. A 22-year-old's
$3,000 Roth IRA contribution, for example, could grow to more than $95,000
by the time she's eligible for full Social Security benefits. Put off that
contribution by 10 years, and her contribution will grow less than half as
big, to about $44,000. Both examples assume eight percent average annual returns.
It's up to you to put limits on how much debt you're willing to incur. As
with mortgages, credit cards and most other kinds of debt, lenders are
willing to give you far more money than you can comfortably afford to repay.
Students do face maximums on how much they can borrow under federal student
loan programs. Private lenders have no such limits and will typically lend
students, or their parents, the difference between their college costs and
any financial aid they get.
These lenders know they have a pretty good chance of getting paid back, no
matter how rocky your post-college finances turn out to be. There's a much
better system than in the past for tracking down defaulters, so it's harder
to simply walk away without paying. And even though student loans are
unsecured debt - not tied to any asset, like a house or a car - you
typically can't have them erased in bankruptcy court.
How much can you safely borrow?
Knowing all that, how do you decide how much debt you should incur?
Obviously, the less borrowing you have to do, the better:
- If you're a student, your payments shouldn't exceed 10
percent of your expected
monthly gross income once you graduate.
- If you're a parent, all your debts - including mortgage payments, credit
cards, car loans and education loans -shouldn't eat up more than 35 percent of
your gross pay.
Once you start borrowing, keep track of your debt. It's easy to get
confused about how much you owe, particularly if you borrow from a number of
different lenders.
How can you figure out how much your loans will cost when the interest rate
is often variable? You'll be pretty safe if you figure on a rate of around
eight percent. That's almost twice the current rate for federal student loans right
now, but rates may go up, and most loans are capped at 8.25 percent to nine
percent. (If
you're a parent using a home-equity loan, your rates were fixed when you
borrowed the money. If yours is a home equity line of credit, however, your
rates are variable, so use an 8eight percent interest rate to be conservative.)
At eight percent, each $1,000 you borrow will cost you about $12 a month to repay,
assuming a 10-year loan. If you're a student and you borrow the maximum
allowed under current federal student loan programs - $23,000 in subsidized
and unsubsidized borrowing for undergraduates who are still their parents'
dependents - your monthly payments will be around $276.
That payment level should be manageable if you're making at least $33,000,
which means you'd better be an accounting or business major. Starting
salaries in those fields currently range from around $36,000 for business
administration types to $43,000 for management information systems
graduates.
Liberal arts grads, on the other hand, generally have to settle for salaries
under $30,000 to start. Beginning pay for psychology majors is about
$26,000, while English majors are getting about $28,000. At those pay
levels, you're better off borrowing no more than about $18,000 over your
college career. (Curious about what pay to expect in your field? The
National Association of Colleges and Employers conducts an annual survey for
many fields. You also can ask guidance counselors, or simply use an Internet
search engine. If you want to be an educator, for example, type "starting
salaries for teachers" into a search engine and explore the results.)
Yes, your salary should go up over time, which should in theory make your
payments more manageable. But your financial obligations also will multiply.
Chances are you'll be buying a home someday, hooking up with that special
someone, perhaps having kids. You'll need cars, furniture, retirement
savings, college savings for your own offspring.
No heroics from the parents
Parents, too, need to put limits on their borrowing, since too much debt can
keep them from adequately funding their other goals, such as saving for
retirement.
If you've already got a mortgage, car loans and significant credit card
debt, you may already be over the recommended 35 percent-of-pay debt limit. Someone
making $60,000 a year with a $1,250 mortgage, $400 auto payment and $200
minimum payments on credit cards wouldn't have any room left under this
guideline to borrow for college. If helping to pay for Junior's education is
important to you and you understand the risks you're taking, you could push
the debt limit to 40 percent or a bit higher - but again, don't go overboard.
Parents also should avoid the temptation to tap all their home equity to pay
for a child's college education. If you borrow more than 80 percent of the value of
your home, including your first mortgage, you pay higher interest rates and
have little cushion left for emergencies.
Once you've decided the maximum you can afford to borrow over four years,
don't take out more than 15 percent to 20 percent of that amount for the first year.
College costs tend to rise over the typical student's undergraduate career,
and lenders estimate you'll need as much as two-thirds of the money to pay
for the last two years.
As an example, look at the maximum borrowing limits for subsidized Stafford
student loans, a popular federal loan program. The first year limit is
$2,625, the second year maximum is $3,500 while the third and fourth year
top out at $5,500.
Some alternatives
What if you find you can't prudently borrow the amount you need for school?
Then you should consider some alternatives, if you haven't already:
- If you're the student, look for a college that wants you. Your financial
aid package will be much more attractive at a school that's trying to
recruit you than at one where you're fighting to get in.
- Consider lower-cost alternatives. Attending a two-year school and then
transferring to a four-year institution is often a good way to cap costs. So
is opting for a top-rated public university rather than a mediocre private
one.
- Get a job. Most students can help contribute at least some of their
college costs. A part-time job during the school year, a full-time job in
the summer or alternating a semester of work with a semester of study will
all help defray education expenses.
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