Financial literacy: The key to smart, successful student loan borrowing

Most college students have little or no prior experience managing debt. This lack of financial literacy can cause them to borrow more than they need, choose expensive loans or make other costly mistakes. 

Taking out student loans is one of the biggest financial decisions many young people will make. It’s critical to understand the basics of borrowing before signing a loan agreement.

Studies show most student loan borrowers cannot correctly answer even basic questions about loans and repayment. Without good financial literacy, students are vulnerable to taking on unaffordable debt or falling prey to predatory practices. A little knowledge can go a long way toward smarter borrowing and better outcomes.

Fewer than one in three students can answer basic student loan questions

The 2019-2020 National Postsecondary Student Aid Study tested borrowers on basic loan concepts. Students were asked:

• Can the government garnish wages for unpaid federal student loan debt? 
• Can the government report unpaid federal student loan debt as past due to credit bureaus?
• Can the government retain tax refunds and Social Security payments for unpaid federal student loan debt? 

Here’s how they answered:

The correct answer to all three questions is “Yes,” yet only 30 percent of students answered all three correctly.

The low levels of loan literacy demonstrate significant deficits in the ability of college students to manage their money. 

Younger students (ages 15-23) had the lowest accuracy at 25 percent, compared with 43 percent among borrowers age 30 and older, suggesting that experience improves understanding.

There are several tips you can follow to help you borrow responsibly.

Budget before you borrow

Budgeting before you borrow can help you limit the amount of debt. Start by developing a simple budget of your college costs and the resources you have available to pay those costs. 

College costs include tuition and fees, room and board, books, supplies and equipment, transportation and essentials. Financial resources include past income (savings), current income and financial aid and future income (student loans). 

Borrowing too much money will make it harder to repay your student loan debt. Borrow only what you absolutely need, not the maximum available.  Live like a student while you’re in school, so you don’t have to live like a student after you graduate. 

If you graduate with too much student loan debt, it may affect your future financial goals. Students who graduate with too much debt are more likely to delay major life events such as buying a home, starting a family, going to graduate school and saving for retirement. The decisions you make today may impact tomorrow’s financial goals.

Know how much you can borrow

Student loan debt is reasonable and affordable if you will be able to repay the debt after graduation. Your ability to repay the debt is based on the amount of debt and on your income after graduation.

Generally, if your total student loan debt is less than your annual income, you should be able to afford to repay the student loans in a reasonable 10 years or less. 

There are many resources for learning about the average starting salary for your intended career. These include Salary.com, Payscale.com, the Bureau of Labor Statistics, College Scorecard and the National Association of Colleges and Employers. 

If you borrow above your starting salary, you may struggle to repay your student loans under the standard 10-year repayment term. Instead, you will need an alternate repayment plan, such as extended repayment or income-driven repayment, to afford the monthly student loan payments. 

These repayment plans reduce the monthly loan payment amount by increasing the length of the loan, typically to 20 or 25 years. That means you will still be repaying your own student loans when your children enroll in college.  

If what you’ll need to borrow exceeds what is reasonable based on expected earnings, consider:

• Attending a less expensive school, such as an in-state public college.
• A college with a generous “no loans” financial aid policy.

Choose the right loans

Borrow federal first, because federal student loans are cheaper and more available than private student loans. They have lower fixed interest rates. Eligibility does not depend on your credit history and they do not require creditworthy cosigners. Federal student loans also have more flexible repayment terms and longer deferments and forbearances.

But, federal student loans have fixed annual and aggregate loan limits. If federal loans aren’t enough, shop around for private loans. Compare offers from multiple lenders and, if possible, apply with a creditworthy cosigner to get a better rate.

If Congress decides to repeal the Parent PLUS and Grad PLUS loan programs, some students may need to borrow private student loans. However, if you stick to the federal student loans, you are unlikely to borrow more than you can afford to repay. 

Understand your student loans

You need to know certain key details of each of your student loans:

• Type of loan (federal or private)
• Name of the lender and loan servicer 
• Interest rate  (fixed or variable)
• Current loan balance and monthly loan payment
• Repayment plan and term
• Deferment, forbearance, and forgiveness options

It is important to understand the total cost and mechanics of borrowing, not just the monthly payment amount. For example: Every dollar you borrow could cost about two dollars by the time you repay the debt. Increasing the amount you pay speeds your progress in paying down the debt. By contrast, extending the repayment term reduces the monthly payment, but it also means paying more interest overall.

Students who don’t understand their student loans are more vulnerable to predatory lenders and student loan scams.

Pick the right repayment plan

Choose the repayment plan with the highest monthly payment you can afford. A higher monthly payment reduces the total interest paid over the life of the loan. It also causes the loan to be fully paid off sooner, freeing you from the burden of student loan debt. 

If payments are unaffordable, choose an income-driven repayment (IDR) plan rather than delaying repayment through deferment or forbearance. An income-driven repayment plan bases the monthly payment on a percentage of your income, as opposed to the amount you owe. While the federal government offers several IDR options, the large majority of private lenders do not offer these plans.

If you have a short-term financial difficulty, deferment and forbearance are options for suspending the repayment obligation, and they are available from some private lenders. Interest may continue to accrue, increasing the amount you owe, so these are not good long-term options. But, if you need to take off time from work for medical or maternity leave, these may provide some financial relief. 

If you have a long-term financial difficulty, a deferment or forbearance is just going to dig you into a deeper hole. Imagine you have a job, but it doesn’t pay well enough for you to repay your student loans and your prospects for increasing your income are limited. In such a circumstance, it may be better to choose an income-driven repayment plan, if it’s available to you. Otherwise, consider exploring options for extra income, like side hustles.

Sign up for autopay

Autopay will transfer your monthly student loan payments automatically from your bank account to the loan servicer. Autopay reduces the risk of missed payments. Many lenders offer an interest rate reduction of 0.25 percent to 0.5 percent as an incentive for enrolling. 

Track your student loans

Maintain a spreadsheet that lists all of your loans, including their outstanding loan balances, loan payments, interest rates, repayment plans and other loan terms, as well as your payment history.

This ensures you have documentation in case your loans are transferred to a new servicer.

Bottom line

Good financial literacy gives students the tools to borrow wisely, repay responsibly, and achieve financial independence. Taking the time to gain loan literacy now can prevent regret — and debt — later.