Weigh options carefully when repaying student loans

Your Money

November 19, 2006|By Tami Luhby | Tami Luhby,Newsday

With the cost of higher education soaring every year, students often are forced to take out substantial federal student loans. And many are unprepared to write those checks when it comes time to pay back that debt.

Defaulting on federal school loans, however, can have serious ramifications, including wrecking credit histories. That's why lenders provide options for reducing monthly payments to a more manageable level. These range from consolidating debt to paying only interest to deferring payments entirely for up to three years.

These measures, however, can stretch out payments for decades and add thousands of dollars in interest to the total bill. But some people have no choice.

Take Stephanie Gonsalves of Brooklyn, N.Y. She took out $150,000 in loans to pay her way through the University of Arizona and then Brooklyn Law School, from which she graduated in 2005. Now an assistant district attorney in Brooklyn, Gonsalves receives an annual salary that's only one-third of her debt. So she was forced to consolidate and defer payments on her federal loans and pay only interest on her private loans for the next three years.

"I can't even imagine being able to [pay back the full loan] on a public interest salary," said Gonsalves, 29. "I wouldn't be able to live. I'd have to move back to Arizona to live with my parents."

Thankful that there are different repayment options, Gonsalves said it was very important to her to get trial experience at the district attorney's office. Still, she has to fork over $566 a month, forcing her to live with a roommate and save next to nothing for the future.

"The benefit outweighs the cost," she said.

Others just choose not to pay their debt - and this is a mistake with long-term consequences, experts said. The default rate on federal loans began climbing in fiscal year 2004 after falling to an all-time low of 4.5 percent the previous year - a far cry from the 22.4 percent rate of 14 years ago. The most recent figures show that the rate for those defaulting before Sept. 30, 2005, rose to 5.1 percent, a jump of 13 percent over the year before, according to the U.S. Department of Education.

Some experts predict that the numbers will continue to rise, especially since the interest rate increased to 7.14 percent for federal Stafford loans, the most common source of college loan funds, as of July 1. The 2 percentage-point increase was one of the largest in the federal loan program.

"As student debt rises to fill the widening gap between what families can afford in an era of stagnant aid and the real cost of college, we're concerned that more people than ever will be struggling to make their payments and be at risk of default," said Lauren Asher, associate director of the Project on Student Debt, a nonprofit research and policy group based in Berkeley, Calif.

When a borrower defaults on a student loan, the government can take several harsh measures. It can garnishee wages, telling employers to forward 15 percent of pay toward repaying the debt. Borrowers can forget about seeing any income-tax refunds, and should be prepared to potentially pay thousands in collection costs and penalties. Declaring bankruptcy does not absolve them of the responsibility.

Finally, the default will appear on credit records for the next seven years. This could hamper borrowers in renting an apartment, securing a mortgage or even landing a job.

The worst thing graduates can do "is run into economic hardship, avoid the situation and find themselves after a period of time under water and really in dire straits," said Mark Jacobs, vice president of Goal Financial, a student loan company based in San Diego.

To ease the burden of a student loan a borrower can arrange for payments other than the standard plan. There is a graduated option under which monthly payments start smaller and increase gradually over the life of the loan. There is also the income-sensitive plan under which the monthly charges are based on a percentage of income. Or if borrowers consolidate their loans, they can repay them over 15 to 30 years, depending on their debt level.

If borrowers lose their job or go on to graduate school, they are entitled to defer payment on federal student loans. The federal government will pay the interest on the subsidized portion so debt levels won't balloon.

A borrower also may qualify for deferment if undergoing economic hardship, which is based on a mathematical formula. The borrower can have up to three years of deferment for unemployment and another three for economic hardship. Borrowers are permitted to pay interest - and even send in some money to pay down the principal - during this time.

Borrowers also can apply for forbearance, which is at the lender's discretion. Granted in six-month increments, forbearance allows borrowers to delay repayments, but there is no interest subsidy. At some point, the bill will come due, so graduates need to save money while they are in this grace period.

"The borrower is putting off the inevitable," said Patricia Scherschel, vice president of loan consolidation at Sallie Mae, a Reston, Va.-based lender. "Hopefully during that time, the borrower will be in the position to repay the loan when the deferment or forbearance is up."

These options, however, should not be taken lightly. For instance, it can be difficult to secure an economic hardship deferment because it is based on a complex formula involving the poverty line, Asher said. And extending the payments winds up costing a lot more in interest.

Tami Luhby writes for Newsday.

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