Daily Aid 96: Determining how much to borrow in student loans

From the Wall Street Journal:

Another option is to pursue an advanced degree and hope that the job market is better when you’re done. But don’t do this if you’d end up with an unreasonable amount of debt, says Christopher Penn, spokesman for the Student Loan Network.

He suggests limiting total borrowing to no more than 100% of what you expect your annual after-tax income to be upon graduation, something that can be difficult to judge in these extraordinary times.

Commentary

Thanks again to Anna Prior for the interview. I wanted to dig a little deeper into this and show you some concrete steps for how to make this judgement about what you should borrow. First, a little math.

Most federal student loans like the Stafford loan have a 10 year repayment term. Assuming you neither defer nor consolidate, you repay the balance of the loan plus interest over a decade. Logically, then, you pay off 10% of the loan each year.

Most consumer personal finance advocates suggest keeping your debt repayments under 10% of your budget.

Thus, if you know what your annual salary will be after graduating (or have a pretty good guess) you know that 10% of that is what you should be aiming to use for personal finance debt service. Assuming that student loans are the bulk of your debt after graduation, you work backwards to arrive at the conclusion that you shouldn’t borrow in total more than your first year’s salary.

Obviously, there are a whole bunch of factors not taken into account – whether pay raises and cost of living adjustments are enough to offset accrued interest, etc. – but I suspect these largely cancel each other out, so for practicality’s sake, let’s say that you should never borrow more in total student loans than you’ll make your first year after college.

But wait, I can hear some folks saying – how can you possibly know what you’ll make after college?

You don’t. But you can make some fairly educated guesses. Take a look at the Bureau of Labor Statistics or any salary finding web site and you can see current projected annual incomes for a variety of professions and fields.

What if you’ve borrowed more than 10% of your projected annual income? Get straight to the budgeting process so you can figure out how much you need to make and how much you need to cut back spending so you can get that debt under control. Look to student loan consolidation as a way of reducing the monthly payment for a little while as you get your career going (but acknowledge that if you don’t make more than the minimum payment, you will pay more in interest overall). If consolidation isn’t an option, explore deferment and forbearance, again acknowledging that they will cost you more in the long run.

Scholarship Update

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Mail Bag

Jeff writes:

I need some insight as how best to address this. In April 09 Federal Direct Parent loan will start sending installment invoices. My wife whose name the loan is in says to defer that payment until our son is finished college. I am under the impression it would be best to establish a good payment record for one year then defer. Does it matter? Will establishing a payment record be taken under consideration when we request additional funding for our son’s education. Currently, he will be entering his sophmore year at Virginia Tech.

A payment record will help as the PLUS loan is a credit based loan, but honestly, if you can afford to make interest payments throughout school, you’ll have less to pay on the back end – any interest that accrues while your son is in school capitalizes at graduation, including the PLUS loan if you defer all payment. Better to pay off the interest if you can while he’s in school so that the balance doesn’t take a large lump sum in a few years.