Educating Students on How to Handle Debt

Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. An earlier version of this article appeared May 21.

Recent government estimates tab the nation's student debt load at more than $1 trillion, and many students and their families face tough choices in determining how to pay for college without mortgaging their financial futures. Jeffrey Hanson is a former director of borrower education services at Access Group, a nonprofit student loan provider, and also has served as director of financial aid at Northwestern University. Today he travels the country speaking to college students about financial literacy and debt management. He recently answered our questions about the financial picture for today's college students and what it means for their futures.

What is the single most common misconception you encounter when speaking with college students about their finances?
Perhaps the biggest misconception I see with students relates to what they think they "need" while in school. Having access to the latest technology, staying "connected" to the virtual world, having more personal space, and keeping up with the latest trends in fashion, exercise, food, and entertainment/recreation seem to be a part of what some, if not many, students expect from their college experience. But this all comes at a price. And if they are paying for it with financial aid, they are likely paying more than they can afford as a student. 

"Living like a student" used to mean being thrifty and cheap--living with roommates, eating macaroni and cheese, walking to school rather than driving, and so on. Now students tend to have higher (and therefore, more expensive) lifestyle expectations while in school, and this is contributing to the rising cost of their education. As such, they need to be encouraged to be more discriminating when it comes to differentiating between what they need while living as a student versus what they want. It should be remembered that success in school comes from how well you perform academically and whether or not you get the job you want once you graduate. It is not based on how well you live, what you wear, what you drive, or any other factor related to how much you are spending while in school.  

In addition, students tend to lack an adequate understanding and knowledge of their own finances and the impact that student loan debt will have on their future. It is important that they fully realize what it will mean to them to repay the student loans they borrow while in school. Although they likely do have at least a cursory understanding that they must repay all that they borrow, it is unclear if they fully understand that in borrowing loans to pay for school they really are living off their future income. As such, borrowing as little as possible to attend the school they have chosen is very important to achieving long-term financial well-being. It also requires that they take an active role in managing their own finances. Relying on parents or other family members to take care of their finances and the financial aid they might be using to pay for their education causes them to be ill-prepared for the financial realities they will face once they graduate.

We've seen a remarkable rise in the cost of higher education during the past decade or so. Where do you see the trend going from here, and what advice do you have for students and parents trying to prepare for this future cost?
I think that families should anticipate costs will continue to increase, though the rate of increase hopefully will abate somewhat as institutions attempt to further contain expenses and seek alternative sources of revenue. As such, paying for a post-secondary education will continue to require that families save as much as possible to pay those costs. 

Students and families will increasingly need to rely on the financial aid that is available, and that will require that they understand how and when to apply for assistance. The U.S. Department of Education provides information, tools, and resources for students and families. Another important source of information is the school(s) the student is considering attending. Each school's website should contain detailed information about the financial aid that is available, how to apply for it, and when application materials need to be submitted. In addition, the admissions and financial aid staff at each school are important resources when it comes to helping families navigate the financial aid process. Also, families should research scholarship and grant opportunities from private organizations, civic groups, and other sources.

What trends are you seeing with regard to financial aid?
More students need financial assistance to help defray the cost of higher education, and increasingly that aid comes in the form of student loans. Grant funding both at the federal and state level is not keeping pace with rising costs in tuition and other expenses, and families seem to be less able to help cover the costs.

Student indebtedness is increasing as grant and scholarship funding have failed to keep pace with rising educational costs. As such, borrowers likely will need to rely more heavily on the Income-Based Repayment plan [which caps required monthly loan payments based on the borrower's income and family size] to repay their federal student loans. In addition, more borrowers might ultimately qualify for some form of loan forgiveness either through the forgiveness available in the IBR plan or because they work for 10 years in a qualifying public-service position and become eligible to apply for forgiveness of their remaining Federal Direct Student Loan balance as part of the Public Service Loan Forgiveness program. In either case, this will represent an increased cost to the federal government over time as it forgives the remaining loan balances.

Many students are graduating with tens of thousands of dollars of debt. What strategies do you recommend to help them get out from under it? Do you suggest paying loans off as quickly as possible? Waiting in order to build up savings?
Students need to educate themselves on the terms and conditions of their loans so that they can take advantage of the flexibility inherent in the federal student loan programs. That flexibility includes the availability of five different repayment plans on Federal Stafford, Federal Grad PLUS, and Federal Consolidation Loans (the federal loans most students rely upon to finance their education). Those plans include the Income-Based Repayment, or IBR, plan that bases the monthly payment on the borrower's household adjusted gross income, household size, and the federal poverty guidelines published by the U.S. Department of Health and Human Services. More information about each of the payment plans is available at the Department of Education's student loan website. For more about the IBR plan, borrowers can check out this website which was created by the Project on Student Debt to educate borrowers about this program.

The following factors should be considered when choosing a repayment plan and in deciding how quickly to pay off student loans:

• How much can you afford to pay each month based on your budget (income, expenses, and so on)? This may restrict your choice and limit your viable repayment options.
• What are your financial goals in both the short and long term, and how can you leverage the repayment of your student loans to help you more quickly achieve those goals? In essence, you need to evaluate the opportunity cost of paying down your student loans more quickly versus using a portion of the funds for investment-related expenditures such as saving for the down payment on the purchase of a home, investing for retirement, saving for your children's education, and so on.
• Do you have other consumer debt such as credit card debt that has a higher interest rate than your federal student loans? If so, paying less on your student loans so that you can more quickly pay off that higher rate consumer debt would save you total interest expense.
• Do you have funds saved for emergencies? You should have at least six months worth of your average monthly expenses saved in case you experience financial hardship such as loss of a job or a reduction in your income.

Students need to realize that federal student loans are probably the most flexible form of personal credit they will ever possess. As such, they should evaluate all their options when repaying that debt and leverage the flexibility that is inherent in the federal loan programs so they can achieve the goal of repaying their loans as well as the other financial goals they have set for themselves.

What long-term effects do you think these heavy debt loads will have on the current generation of college students? Do you think they will ultimately be more comfortable living with debt than previous generations or more averse to it? 
The long-term effects likely will include the following:

• Borrowers will be taking longer to repay their student loans.
• Borrowers may need to delay certain financial actions such as purchasing a home, investing sufficient amounts for retirement, and paying for their children's education.
• Borrowers might be forced to make career decisions that are based more on debt and other financial considerations than on work they enjoy.
• Borrowers might have to work more years than anticipated before they can afford to retire.

Students likely will have to become more comfortable having educational debt in the future. It will be a reality that most will have to face if they want to fulfill their educational goals.