Avoid the Student-Loan Debt Trap

How do you make the most of student loans without getting in over your head?

Does this sound familiar? Consumers clamor to buy a desirable commodity. To make the purchase easier, the government makes loan money available. Buyers rush to borrow, increasing demand and pushing up prices. Buyers borrow even more, creating a vicious cycle until…

Shades of the housing boom — only this time the scenario is playing out with student loans. With more than $1 trillion in federal and private student loans outstanding, the news media have suddenly discovered the issue, and observers are warning of a student-loan bubble.

In my opinion, the real problem is that student loans represent a double-edged sword. The very loans that are supposed to help students pay for college also contribute to driving up costs, and that encourages students to borrow even more (see “The Student Loan Rate Debate”).

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A lot of people have suggested solutions to this conundrum. But in the meantime, students and families are faced with a practical problem. How do you make the most of student loans, if necessary, without getting in over your head? It's a subject we've covered extensively here at Kiplinger—in articles such as "Lighten the Burden of Student Loans" and "How to Limit Student-Loan Debt." Given the sudden surge in interest, my advice bears repeating: The best way to get out of the student-debt trap is to avoid it altogether.

Double down on saving. Every dollar you save is a dollar you won’t have to borrow or rely on student aid to provide. State-sponsored 529 college-savings plans are one of the best ways to save (see our choices for the top plans).

The good news is that assets in 529 accounts topped $158 billion in the first quarter of 2012, reports the College Savings Foundation. In addition, 529s are reaching a broader market, with more accounts opened in smaller amounts. Unfortunately, a survey by financial-services firm Edward Jones found that 62% of those questioned, and about half of those with children, still didn’t know what a 529 plan was. For a guide to 529s and other saving strategies, see “3 Smart Ways to Save for College.”

Pick a school you can afford. Your kids might want to go to NYU, but if State U fits your budget, go there. It isn’t worth borrowing $100,000 that your kids won’t be able to pay back to go to a pricier school. Start your search with Kiplinger’s lists of the best values in public colleges and private colleges. Our list now gives extra credit to schools that have a good track record for getting kids in and out in four years, saving you money.

One of the rules my husband and I had with our kids was that we would pay the bulk of their undergraduate costs and they would cover grad school. Now, with advanced degrees becoming so necessary in some fields (and so expensive), I might amend that. Consider holding back some savings for grad school, even if it means that kids attend a less expensive college.

Go a different route. In today’s competitive economy, everyone needs post-high-school training, but that doesn’t necessarily mean four years on campus. It could be as simple as attending community college for a couple of years and then transferring.

Or you could get a foot in the door with a certificate awarded by a community college or a private vocational or technical school in a field such as computer and information services, electronics, or business and office management. A study by the Center on Education in the Workforce at Georgetown University found that certificate holders sometimes earn as much as workers with an associate’s or bachelor’s degree, or even more.

I predict that as costs continue to rise, we’ll see innovative ways to deliver affordable education, such as online learning patterned on the popular Khan Academy (www.khanacademy.org) or Western Governors University (www.wgu.edu). Harvard and MIT both offer free online courses at www.edXonline.org.

Know what you’re getting into. If I could give families just one piece of advice, this would be it: Run the numbers to see how much it will cost you to repay your loans. FinAid.org has a simple loan repayment calculator based on the starting salary for your chosen profession. Ten colleges and universities, including Syracuse, Vassar, and the state universities of Maryland, Massachusetts, New York and Texas, recently announced that they would standardize their financial-aid awards to disclose, among other things, the estimated monthly payments for federal student loans that students would likely owe after graduation.

If you must borrow, stick with federal loans, which give you fixed rates and flexible repayment plans. For dependent students, the borrowing limit for federal Stafford loans for four years is $27,000, with a lifetime cap of $31,000. Meanwhile, the average student-loan debt for students who borrow was $22,000 for students at public four-year schools and $23,100 at private schools in 2009-10, reports the College Board. One rule of thumb is that you should limit any borrowing to no more than your expected annual starting salary. So if you think you can earn $25,000 or more, then borrowing at these levels seems manageable. (See “7 Smart Ways to Pay for College.”)

If you end up borrowing more money using private loans, it’s riskier. These loans generally require co-signers (putting parents on the line if kids can’t make the payments), they don’t have the same flexible repayment plans as federal loans, and they make it easy for kids to get in over their heads. Remember, if you have to borrow $100,000 to go to college, you can’t afford it — especially if you want to major in history, psychology or another common major that many schools with lower price tags offer. Even then, it makes sense to combine a liberal arts major with something that’s more marketable — a foreign language, business classes or computer skills, say — so that you can increase your earning power and enhance your ability to pay back those reasonable student loans.

Janet Bodnar

Janet Bodnar is editor-at-large of Kiplinger's Personal Finance, a position she assumed after retiring as editor of the magazine after eight years at the helm. She is a nationally recognized expert on the subjects of women and money, children's and family finances, and financial literacy. She is the author of two books, Money Smart Women and Raising Money Smart Kids. As editor-at-large, she writes two popular columns for Kiplinger, "Money Smart Women" and "Living in Retirement." Bodnar is a graduate of St. Bonaventure University and is a member of its Board of Trustees. She received her master's degree from Columbia University, where she was also a Knight-Bagehot Fellow in Business and Economics Journalism.