5 Mistakes to Avoid When Taking Out Student Loans

1. Failing to exhaust free money first.

Loans are not free money. They must be repaid, usually with interest. Every dollar borrowed will cost about two dollars by the time the debt is repaid in full. Focus instead on gift aid, such as grants and scholarships. Then, consider money that is earned, such as student employment, education awards for volunteer service, employer tuition assistance, and military student aid. Also, save for college in advance, since it is cheaper to save than to borrow. If debt is unavoidable, consider using a short-term tuition installment plan instead of long-term debt.

2. Taking on too much debt.

Students (and parents) should not borrow more than they can afford to repay in a reasonable amount of time. Don’t treat loan limits as targets. Instead, keep debt in sync with income after graduation. Total student loan debt at graduation should be less than the student’s expected annual starting salary, and, ideally, a lot less.  If total debt is less than annual income, the borrower will be able to repay his or her loans in ten years or less.

3. Borrowing private student loans instead of federal.

Exhaust eligibility for federal student aid, including federal loans, before turning to private student loans. Always borrow federal first, because federal student loans are cheaper, more available and have better repayment terms and conditions than private student loans. Federal student loans offer flexible deferment and forbearance options, income-based repayment and public service loan forgiveness.

4. Misunderstanding the difference between fixed and variable interest rates.

Fixed interest rates remain unchanged for the life of the loan. Variable interest rates may change periodically, perhaps, even monthly. Even if the interest rate on a variable-rate loan is initially lower than the interest rate on a fixed-rate loan, the variable-rate loan may ultimately be more expensive if the interest rate increases significantly over the life of the loan.

Variable interest rates are expressed as the sum of a variable-rate index, such as the Prime Lending Rate or LIBOR index, and a margin. Don’t ignore the index. A variable-rate loan with an interest rate of Prime + 6% is not a 6% fixed-rate loan. The actual interest rate may be much higher than 6%.

5. Cosigning a loan without understanding the consequences.

Cosigning a loan may help the borrower qualify for a loan and may reduce the interest rate. But, a cosigner is also a co-borrower, equally obligated to repay the debt. The cosigned loan will be reported on the credit history of both the borrower and cosigner. This may affect the cosigner’s ability to qualify for other debt, especially if the borrower is late with a payment or defaults on the loan. The lender can seek repayment from the cosigner at any time, and many will do so the first time the borrower is late with a payment. Although the lender may offer cosigner release as an option, cosigners often complain that it is difficult to qualify for cosigner release.

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