Every year, around this time, I am always reminded of the tragedy of the Titanic. It was on April 15, 1912, 107 years ago, that the Titanic sank into the icy depths of the Atlantic ocean, a mere 2 hours and 40 minutes after being struck by an iceberg.
Her brave masters knew of the perils – they even saw the iceberg coming. What they failed to reckon with were the sheer destructive power of the berg, and the unsuspected vulnerabilities the ship herself carried, dooming most of the passengers and crew to a watery, icy fate.
In a way, your venture to reach the safe shores of debt-free living, unshackled by heavy student loans, is also like the challenge facing the Titanic. But with better foresight and prudence than her navigators, and much better protection for your own financial ship, I’m rooting for you to beat the bergs AND anchor safely at harbor with the dawn of a bright, new, debt-free day.
The three icebergs threatening your ship
Student loans are different from other kinds of debt in many ways. But there are three dangers that are particularly menacing in the case of student loans, far more than they matter in other dealing with other forms of debt, even if those other debts are much bigger. The primary reason for this risk that like the monster that struck the Titanic, these dangers lurk with most of their hulk unseen, but deadly, just under the surface.
Capitalization and deferment:
When you have student loans but are still in school, you’re typically not under an obligation to make any payments on your loans – the payments are held in abeyance until any of the repayment triggers are set off: you graduate, for example, or drop to less than half-time enrollment.
Just because you don’t have to make payments doesn’t mean that your loans aren’t getting bigger – unless your loans are subsidized, you’re still being charged interest on these loans.
But the most deadly danger from this berg doesn’t come from the fact that your loan is being charged interest while in school – most people are aware of that. Instead, what piles on the harm, is the fact that the interest on these loans gets capitalized regularly.
When any amount such as unpaid interest gets capitalized, it means that the unpaid interest gets added to the loan itself, and is treated just as if it were an actual sum of money that was disbursed to you. And all of a sudden, the pace at which your loan is taking on interest just accelerated, just the way the doomed ship started taking in more and more water as the minutes ticked by.
Multiply this impact by the number of years you spend in school – a lot longer if you’re also going to go to graduate or medical school, and all of a sudden you begin to see the gigantic magnitude of what capitalization can do to your tender pocketbook.
The remedy? Aside from minimizing how much you borrow at the start, your next best bet is to make payments as early as possible, and as often as possible, even when you are still in school. Extend out the time at which the disbursements will be made, to a time as late in the semester as possible.
Earn money in college any way you can, and stash all the cash you can spare towards making payments on your student loan – taking care to designate all of it towards your principal outstanding – this is what will effectively stem the damage.
Here’s another beast that can inflict significant damage if you’re not careful: negative amortization, fondly called “neg am” by its friends in the industry.
Negative amortization refers to that unpalatable situation that arises when you keep making payments on the loan. Then you turn around and look at the loan balance the end of the year, and what do you know – it has actually gotten bigger!!
Negative amortization happens when the payments you make every month are insufficient to cover even the interest that was charged on the loan for that month. As a result, the unpaid leftover interest gets added to the loan balance, making it bigger and bigger each month. This is usually the case when borrowers choose an income-driven repayment plan on their federal loans and the payment is not enough to cover the interest for the month.
Of course, on the right income-driven repayment plan, you still have the attractive possibility of loan forgiveness after 10,20 or 25 years, depending on the plan and your situation. But even so, the balance is going to put a big damper on your credit capacity in the intervening critical years of your life when you may have other big life plans.
What’s the solution? The most critical levers are first, to move heaven and earth to pay at least the interest charged each month on your loans. Second, where it makes sense, aggressively seek to find lower interest rates so you can continue to make payments but have them make a much bigger dent on your loan amount. But please be careful: if you refinance out of a federal loan into a private loan, you will lose all protections including the possibility of loan forgiveness.
There is a third possibility: loan consolidation. Loan consolidation is a free option provided by the government on your federal loans. This is what it means: the government simply takes all your qualifying federal loans, lumps them together into one big loan, and extends out the payment over a longer period (which depends on how much your new loan amount comes up to) that you repay with a single monthly payment. And economically, the interest rate won’t change: the “new” interest rate is simply the equivalent of all your rates on the loans, adjusted for the size of the loan. (In financial parlance, this is called your “weighted average interest rate”).
While loan consolidation is definitely an option, I always favor more aggressive approaches that reduce the overall cost of carrying the loan and minimize the net amount you have to pay back – things like lowering the effective interest rate, accelerating payments and exploring forgiveness options.
Fees, fees, everywhere
The third big danger on your journey comes from fees: the biggest of these are origination fees, which can be as high as ten percent of the original amount borrowed. Then there may be other fees nickled and dimed through school or after you graduate. Think about it: the bank making the loan gets a virtually captive borrower, and charges you a big fee just for the pleasure of doing business with you.
If you’ve already taken out loans, there’s not much you can do about origination fees already bundled into your loan – you’re on tap to repay them because you signed a commitment where you said you would. I haven’t yet come across any options or programs that will waive or forgive the fees – if you’re aware of any, I’d greatly appreciate a nudge in the comments section below.
Certainly, though, if you’re planning to take on more debt, or have a sibling, friend or relative about to step into the academic deep waters, there is no time like the present to caution them to steer their ship very carefully amidst these cold waters: look for more options than you’re given, always understand exactly what you’re paying, and for what.
And look for cheaper and better options in the open market beyond merely what you’re given in your letter – competition is a wonderful thing, and out in the open market, banks tend to be lean and mean in the battle for more loan dollars, and you can work this to your benefit.
The way forward: A tighter, lighter hull, safer paths, and more vigilance
So what’s the secret to tightening your chances against icebergs, storms and other perils that may befall you?
The secrets are simple:
First, run a tight, light ship. Take on no expense (weight) that can drag you or slow you down in your quest to get to the other side as quickly and safely as possible
Second, pick safer paths – ones with fewer icebergs likely to lurk. This means accelerating payments as much as possible, avoiding payment-free zones even if you’re in school, by any means in your power, and stashing any excess cash towards your outstanding principal.
Third, keep watch. Fees and other additions to your loans come in innocuous looking letters, statements and packages. Simply learning to read the few lines that matter in your statement can make the difference of several hundred dollars. Also, keep watch for opportunities. Look for forgiveness programs or other schemes such as government-funded programs to offer loan forgiveness in return for serving in underfunded or under-served areas, or in the military or other branches of government. Every dollar forgiven is more than a dollar you won’t have to pay back, or pay interest on!
I wish you godspeed and safe arrival on the distant shores!