
To pay for college, I took out lots of student loans. I figured the tax break would probably make it worth it in the long run. Typically, I hate debt and believe in buying everything with money I've already made, rather than money I might have in the future. This is the one exception.
For a long time I thought student loan debt was easy, friendly, debt. It's an investment in the future and the government requires that student loan companies are nice to you by putting a cap on interest rates, etc. And for the most part student loan debt is friendly. But I did learn a couple disturbing things about my loans today. Those revelations will come at the end of this post. First, I want to give a little background on what I've learned about the big mysterious world of student loans. Here's how the process worked for me:
Deciding to go to college
First, I decided to go to college, but I knew I didn't have the money to pay for it. I didn't get enough in scholarships, I'm white and I don't have kids, so I don't qualify for grants, and my parents are not rich. So I decided to take out student loans. I had no idea how the student loan process worked. I just knew that if I asked for money, someone would send it to my school, and I'd pay it back at some other unfathomable time in my life.
Note: I went to three schools over the course of my college career. The process was pretty similar for all of them.
Getting a loan
My (first) school sent me a 60 page packet on my financial aid options (maybe not 60, but there are always lots of letters and forms and brochures and pamphlets). The school is nice enough to include a breakdown of how much school costs and ideas for how I'll pay for it. In the how to pay for it column, most of my financial aid letters said something like,
Loan – Stafford Subsidized
Loan – Stafford Unsubsidized
Loan – PLUS (PLUS loans are student loans parents take out for their children.)
I did get a couple scholarships, but not enough to make much of a dent in the overall cost of my education.
I always thought it was nice that the school assumed my parents wanted to go into debt for my education. Mine didn't, and I don't blame them.
Anyway, the key part of this packet is the student loan application. I'd fill out the application, choose an institution to originate the loan for me (from the list provided by the school), and mail it in.
The origination fee
At some point I got more envelopes in the mail from my school. The papers inside would show that I paid a 4% origination fee to the institution that originated my loan. (According to http://www.finaid.org/loans/studentloan.phtml, the origination fee is a 3% origination fee and a 1% default fee). Which means that if I took out the $3,500 maximum Stafford loan amount, I paid $140 to the originating institution and my school received $3,360. My first school was a whole lot more than $3,500 a year, so the origination fees were way more than $140.
Note: These origination fees are supposed to be phased out by July 1st, 2010, and lending institutions could choose to waive the 1% default fee.
Payments
Students are not required to make any payments on student loans until after they've graduated or quit school and used up the given grace period.
Some student loan companies (all of mine) offer a partial percentage rate reduction for making automatic payments, or for making on time, in full payments for a specified period of time. If a student loan is not in “repayment” (meaning, you're still in school) and you're making payments anyway, you usually do not qualify for these interest rate reductions.
Selling my loans
At some point, the institution(s) that originated my loan(s) sells the loan(s) to another company. This way someone else can service the loans and the first institution can focus on originating more loans.
When this happened any interest I owed on my loans was capitalized. Meaning, it was rolled into the principle. So rather than accruing interest on the original principle amount ($3.500), it is now accruing interest on a higher principle balance ($3,746.25, effective [(1 + effective annual rate) x original principle balance)] see the interest section).
Repeat
Each year this process repeated. Sometimes a loan company that had already purchased my loans from the originator would again resell them. Resulting in more capitalized interest.
Repayment
Here's where student loans get fun. Repayment begins when a student drops below half-time enrollment and uses up the given grace period. When this happens you get to choose from a few different repayment plans, set up automatic withdrawals, and generally forget about your loans.
Repayment is usually for 10 years unless you work out something else with your student loan company.
Interest rates
The interest rate for unsubsidized Stafford loans is 6.8%, fixed for funds distributed after July 1st, 2006. The government also instituted an 8.25% cap on all student loans. For subsidized loans, the interest rate is slowly phasing down (the federal government is paying it, after all).
What nobody told me, and I just found out today, is that interest is typically calculated on a daily basis. Daily!
I'm an overly money-conscious finance geek, how did I not know this? I suppose it was a combination of me assuming that student loans were nice things and that I figured I was getting a pretty good tax break, so why care?
When I had some questions about one of my loans at ACS Education today, the woman on the phone told me that my interest is calculated daily. I called my other two student loan companies and discovered that they're all calculated at a daily rate!
The annual effective rate for 6.8% interest compounded daily is 7.04%. Luckily, none of my loans have an interest rate that high.
Prepayment penalties
Sometimes, if you pay more than your payment due, your student loan company might treat that as a prepayment. Which means they won't take out any payments for however many payments (months) that extra payment covers, but you'll still accrue interest, daily, over that time period.
So when your “prepayment” is over, your next payment might not be enough to cover all the accrued interest. So your next few payments will only cover interest! This is the result of paying extra on the principle of one payment.
I had to spend a half an hour on the phone with customer support from ACS Education to find this out. (And I had to ask for a supervisor for someone to be able to explain to me why a lower outstanding balance and a fixed interest rate resulted in me paying MORE interest than the previous six months!)
So, in the future, if I pay extra on my loan, I have to call ACS and tell them to not treat it as a prepayment! Otherwise, when the prepayment is done, I'll owe more interest than each student loan payment will cover.
The woman I spoke with at ACS insisted this wasn't a “penalty” for prepaying. But she did agree that it wasn't in my best interest to do this without calling them to tell them not to treat it like a prepayment.
Tax benefits
Finally, what makes me not care so much about all the interest bs, is that for all student loan interest that I pay, it's like I never earned that money in the first place.
If your modified adjusted gross income is less than $70,000 (145,000 for joint returns) a year, you can reduce the amount of your taxable income by the amount of student loan interest you paid, up to $2,500. More information here.
When I do the math, though, it's really not much of a tax break.
Say I make $20,000 a year (I don't, I make less).
And assume I pay 20% interest (a rounded average of what comes out of each pay check).
$20,000 x 20% = $4,000 a year in taxes.
With the tax break, if I pay a full $2,500 in student loan interest each year (I don't, I pay less), my taxable income would be $17,500.
$17,500 x 20% = $3,500
So, I would get a $500 tax break for paying $2,500 in student loans. I'm still worse off by $2,000.
Conclusions
1 – don't assume student loans are friendly things.
2 – don't assume tax breaks are beneficial without doing all the math first.
3 – I'm probably better off without the student loans. Maybe in the future when I'm utilizing my great finance degree skills, I'll be better off. But for now, I'm not doing anything any differently than I would have if I hadn't gone to college. Except I might have felt more motivation to find a more lucrative job by now (to prove myself).
shark image from http://hornbillunleashed.wordpress.com/2009/06/16/human-sharks-on-the-prowl/



