How to Keep Student-Loan Debt Under Control

Kiplinger

Over the past few months, I've been following two college-loan stories. The first was the debate in Congress about how high the federal student-loan interest rate should be. The second involved an acquaintance of mine -- I'll call her Debbie -- who's trying to find a way out of student-loan hell.

SEE ALSO: How Much Does College Really Cost?

Back in the late 1980s, Debbie borrowed money to go to a four-year college. After struggling with her grades and being put on academic probation, she switched to a community college. Readmitted to her four-year school, she borrowed even more money and ended up with $17,000 in federal loans.

After graduation, Debbie held a series of low-paying jobs and never made regular payments on her loans, sending in money sporadically. Eventually, the Department of Education turned over the unpaid debt to a collection agency and began garnishing Debbie's wages. With her personal finances in disarray, she declared bankruptcy. But her loans continued to accrue interest and fees.

About a year ago, Debbie got a notice from the Education Department saying that if she didn't increase her payments, she would be subject to tax offset and her refunds would be seized. She figured that it couldn't apply to her because her wages were already being garnished, so she disregarded the notice -- and lost her tax refund. That was the wakeup call she needed to seek help from a friend of mine, who called me (and my Kiplinger colleagues) for guidance.

Although Debbie's wages have been garnished for a decade, she still owes $24,390 in principal, interest and fees. Now she's talking with a credit counselor, who, we hope, will be able to tell her what she needs to do to square herself with the feds and set up a payment plan she can afford.

Deeper issues. While all this was playing out, members of Congress were trying to figure out how interest rates should be set on student loans. They eventually agreed that for new undergraduate loans, the rate would be tied to the government's borrowing costs -- about two percentage points higher than the rate on the ten-year Treasury note -- to make the process less political and more fiscally sensible. To protect borrowers, the rate would be capped at 8.25%.

It was a welcome political compromise, but the debate didn't address fundamental issues involving student loans. As I've written in the past (see Avoid the Student-Loan Debt Trap), student borrowing is a vicious cycle: The very loans that are supposed to help students pay for college also contribute to driving up costs, which prompts students to borrow even more. And the simple fact that loans are available can encourage students like Debbie to borrow more than they should without considering the consequences. Debbie didn't realize what she was getting into, didn't take responsibility for repaying her loans or seeking help to handle them, and was eventually overwhelmed by the system.

Run the numbers. Choosing a college is often an emotional decision for students and parents, and I don't mind being the bad guy who intervenes to bring everyone down to earth. When my son recently went online to apply for federal loans for grad school, he was impressed that the Web site made it abundantly clear he had to pay back the money. "It would likely be expensive, and there would be consequences if I didn't," he says. Unfortunately, he points out, the warning probably came too late. "You're filling out the form to get loans for a school you've already decided to go to."

That's why it's critical for families to run the numbers early to see how much it will cost to pay off college loans and to emphasize to students that the debt must be repaid. One rule of thumb is to limit borrowing to no more than your child's expected starting salary, or even less. FinAid.org has a simple loan-repayment calculator based on average starting salaries in various professions.

Nowadays, a number of loan-repayment programs tie payments to a student's income, which offers some relief to students in low-wage jobs (see 5 New Rules on Federal Student Loans). But ultimately the solution lies with a student's initial decision to choose an affordable education (see How to Limit Student Loan Debt and 4 Alternatives to a Four-Year College Degree).

Radical ideas. Making the right upfront decision is key to controlling your borrowing costs. But on a broader level, I think we also need out-of-the-box thinking to tackle spiraling college costs and student-loan debt.

President Obama has proposed a new college ratings system so that students and families can select schools that provide the best value. We're happy to say that Kiplinger already focuses on affordability in our annual rankings of the best values in private and public colleges. Among other measures, we include graduation rates, financial aid (both need-based and non-need-based) and average debt at graduation.

Other proposals have the potential to shake up the system. On the cost side, for example, Georgia Tech recently announced a three-year master's degree program in computer science that will cost less than $7,000. Classes will be taught entirely through massive open online courses, or MOOCs. MOOCs are catching on as a way of delivering a low-cost education, but the fact that a prestigious institution such as Georgia Tech is offering a degree at a sticker price far below traditional tuition could be a game-changer.

Skin in the game. On the loan side, a number of online money-lending platforms let students borrow now and repay a cut of their income later (see A New Way to Borrow Money). Two members of Congress have introduced a bill that would automatically enroll graduates in an income-based repayment plan and withhold payments automatically.

Glenn Harlan Reynolds, a law professor at the University of Tennessee, argues that schools themselves need skin in the game. He suggests, for example, that federal aid could be tied to an index, and that schools could be on the hook for a percentage of a loan if a student defaults.

That's a radical idea. But I can't help thinking that if, instead of readmitting my friend Debbie after her probation, her four-year school had told her politely that she would be more successful, both academically and financially, by remaining in community college, she wouldn't be in the fix she's in today.

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