If you take out student loans to pay for part of college expenses, the key distinction to keep in mind is the difference between federal student loans and private student loans. In essence, the former are flexible and the latter inflexible. Flexibility is critical when students graduate from college and start repaying the loan.
The most important idea in personal finance is the “margin of safety.” A margin of safety is the bedrock concept for managing money for all seasons and at all ages, including paying for postsecondary education. The basic money question with student loans revolves around which option lets the borrower weather the storms better if there is an unexpected setback, such as a layoff, a pay cut or an illness. By the margin-of-safety metric, federal student loans come out way ahead. Federal student loans are designed to be flexible during the payback period.
For example, the standard repayment schedule keeps monthly payments the same over a 10-year period. However, let’s say your first job is at a nonprofit you want to work for a couple of years, but the pay is low. You might choose the graduated repayment plan. It starts out with low monthly payments that increase every two years over the 10-year period. The extended repayment plan goes out further in years.
That’s not all. There are several income-based repayment plans that slash the monthly tab for most borrowers. These income-based options are probably the best choice for new college graduates without a high-paying job who are looking to establish a career. You can even defer payments without going into default.
Of course, the price tag for stretching out the repayment timetable is a higher overall cost of borrowing. However, since there is no prepayment penalty with federal student loans, borrowers can always accelerate payments later when careers are more settled and incomes are higher.
In sharp contrast, private student loans are simply consumer debt with a different label. Although some of the larger private lenders do offer a sliver of flexibility, the options pale compared with federal loans. What’s more, parents, grandparents, aunts, uncles and close friends of the family usually co-sign these loans so the student can get the best rate. Co-signers are on the hook if the student can’t make the payments.
The bottom line: Embrace federal student loans and shun private student loans even if the latter carry a much lower interest rate. Flexibility is far more valuable for creating a margin of safety.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.