Congratulations. You got into college and start in the fall. Now comes a bitter dose of reality. Perhaps the value of your parents' college savings has tanked. Maybe the home equity loan they'd been counting on to cover tuition didn't go through. Or maybe the summer job you thought was in the bag didn't materialize after all.
Whatever the reason, millions of students rely on student loans to pay for some or all of college. In total, two out of three leave college with student debt. The average: A sobering $22,700 per graduate. (At least they have a degree to show for it; half the students who enter college never graduate, though many are still on the hook for student debt.)
Often, it takes these newly minted graduates one to three decades to pay it off. Given how much, and how long, the commitment is, it pays to know what you're getting--and whether it's the best deal going--before you sign any loan papers.
There are important distinctions between federal and private student loans, but they have one thing in common: neither is likely to be forgiven if you have to file for bankruptcy, making them lasting financial commitments. Unless, of course, you pay them off.
Before you take out a loan, throw aside the cliché that "college always pays" and ask yourself some tough questions. Will salaries in your desired field of study allow you repay the loan?
Put away the rose-colored glasses too. While every law student dreams of making $175,000 as a first-year associate, the reality is that very few earn those eye-popping salaries. Let a large salary be a pleasant surprise, rather than a requirement to pay off debt.
Research the average pay of the field you've chosen by going to the Bureau of Labor Statistics, a federal office that publishes the Occupational Outlook Handbook. Here, you'll find information on projected earnings, expected growth rates and typical work environments for most occupations.
Next, ask potential lenders for monthly loan repayment estimates in writing. It makes little sense to take out $100,000 in student loans to go into a field where you will be making $20,000 a year.
To make sure that you're not getting in over your head, limit the total amount of student debt you take on to the salary that you expect to make the first year out of college. That way, your monthly payments will likely be less than 10% of your take-home salary.
What to do if the numbers don't add up? See if there are other ways to finance some or all of your education. The first, and best, way is to limit what you pay in the first place. That means searching for scholarships and grants that may reduce the costs of college. The federal government lists grants (which do not have to be repaid) at studentaid.ed.gov. Private Web sites, such as FinAid, FastWeb and NextStudent, list scholarships.
Once you've minimized how much you'll have to borrow, it's important to keep in mind that there are two main types of student loans: those backed by the federal government and those issued by banks and other private lenders. In almost all cases, federal loans are the better deal for student borrowers.
"Federal loans are cheaper, they have fixed [interest] rates as opposed to variable rates and they're more easily available" than private student loans, says Mark Kantrowitz, publisher of FinAid, a Web site that tracks the college financial aid industry.
One key difference between federal and student loans is how they charge interest. All federal loans written after July of 2006 have a fixed-interest rate, which means that the rate that you are quoted will not change for the lifetime of the loan. Private loans, in contrast, typically carry variable interest rates, meaning that they often reset every quarter based upon the interest rates that banks pay each other. Lenders will then add a percentage on top of this baseline rate to your monthly payment. There is no legal limit to the interest rate that private lenders can charge you.
The average private loan currently carries an interest rate of 12%, which is about double what federal loans charge, Kantrowitz says. Though both federal and private loans accrue interest while you are in school, you generally won't have to begin making payments until six months after you graduate.
How you repay the loan is another important difference between federal and private loans. Those taking out federal loans are eligible to stretch out repayment plans and lower monthly payments. What's more, new federal legislation taking effect in July will cap monthly payments based on a percentage of the borrower's income.
Private student loans typically come with a 20-year repayment period, and extending them by five years doesn't do much to cut down the monthly payments or make them more affordable. Kantrowitz estimates that extending these loans from 20 years to 30 years will cut the monthly payment by less than 10%.
If federal loans are so great, then why would anyone take out a private loan? The costs of college have increased well beyond the limits of federal loans, which have a cap of $27,000 over four years for students who are considered dependents, and $45,000 for independent students. (Students are currently considered independent if they, among other criteria, were born before 1985, are in graduate degree programs, are married or are veterans. A parent's tax return is not taken into consideration.)
Tuition alone for the average public university costs $26,300 over four years, which is up 6.4% from last year, while the average private university costs $100,500 over four years, up 5.9% from last year, according to the College Board. Private loans, which make up 23% of the student loan market, often fill the breach between the federal loan limit and the bill from the Bursar's Office.
Federal loans come in three main varieties: Stafford loans, Perkins loans and Parent Loans for Undergraduate Students, better know as PLUS loans. The latter are fixed-rate loans with a current interest rate of 8.5%, and are available to cover up to the entire cost of college tuition, minus any other financial aid the student receives.
Repayment on PLUS loans begins either 60 days after the money is disbursed (meaning that your parents may start making payments in the middle of your first semester) or six months after the student takes a course load that is considered less than half-time, which typically means less than six credits. These loans are the responsibility of the parent, not the student.
These loans do require a modest credit check, and will be denied if the parent has an adverse credit history. Foreclosures, bankruptcies, tax liens and repossessions within the past five years can all lead to a PLUS loan being denied. Parents who take out these loans will also pay an origination fee of up to 4% of the loan's value.
For students who take out loans in their own names, Stafford loans are the most common, Kantrowitz says, and do not take a student's, or his parent's, credit history into account for approval. There are two varieties: subsidized and unsubsidized. For subsidized loans, the federal government pays the interest while you are in school. These are need-based loans, and generally go to students whose families have an adjusted gross income (the amount on which you are subject to pay federal taxes) of $100,000 or less.
If you have an unsubsidized loan, however, you're going to be stuck paying all of the interest. You can postpone beginning payments until six months after graduation, at which time it will be added to the total amount that you owe, known as the principle.
The federal government limits the amount of Stafford loans that you can take out, based on what year of school you're in, whether your parents claim you as a dependent and whether your parents were denied a PLUS loan.
For those whose parents claim them as dependents and were not denied PLUS loans, the limits are as follows: Freshmen can take out $5,500; sophomores, $6,500; juniors and above, $7,500. For independent students and those that were denied PLUS loans, the limits increase. Freshmen can take out $9,500; sophomores, $10,500; and juniors and above, $12,500.
Graduate students can take out up to $20,500 yearly in federal loans, but no more than $138,500 total in Stafford loans, including both undergraduate and graduate loans. Students in certain health-related fields are eligible to borrow up to $224,000 over their lifetimes.
Students at certain schools are also eligible for Perkins loans, which are the best deal going. They're federally subsidized, go to students with exceptional financial need and have a 5% fixed interest rate. The downside--a $4,000 annual cap for undergraduate students. Check with your school's financial aid office to see if you qualify.
If you do have to take out a private loan, it pays to remember that you may not get the low interest rates promoted in advertisements. Make sure--before signing on the dotted line--to get in writing a complete explanation of the rate you will be charged, what origination fees the loan carries, if any, and the repayment period. Have a parent or friend read the terms as well. You don't want any surprises.
Your school's financial aid office should offer you advice with your best interests in mind. However, several top schools, including Columbia University, New York University and the University of Pennsylvania, recently paid more than $1 million each to settle charges of wrongdoing in the student loan market.
The best bet? Don't let your enthusiasm for college overwhelm you. Instead, be methodical and have your parent or trusted adviser read over everything and render a second opinion.
Comments or questions? E-mail drandall@forbes.com.