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Stuck with student loans for life?

Your college debts may not be toxic, but making the wrong choice between federal and private loans can be a life-altering decision. Here's what to look out for.

Leah Cowels had always heard that student loans were an investment in her future. Now that she owes $242,000 for an undergraduate degree she isn't using, she's having second thoughts.

"I never really knew what I was going to owe when I got out," said Cowels, 25, who works as a waitress in New Hampshire. "I certainly never knew it was going to be (the size of) a mortgage."


Cowels approached college with all the confidence, dare I say arrogance, of an 18-year-old who wanted what she wanted when she wanted it. She knew her parents couldn't pay for her education at private Ithaca College in New York, but she was determined to go there once she was accepted. Ithaca provided some financial aid but not nearly enough to cover the $35,000-a-year tuition bill or Cowels' living costs, so she applied for student loans.

"I was going to be successful and make a lot of money," Cowels said. "I didn't care if I could afford (the education) or not."

Her plan was to major in sports management and then get a law degree so she could be a sports attorney. Unfortunately, a disastrous internship with the Boston Celtics changed her mind.

"I hate business," she said. "I hated every second of it."

Debts stymie new career goal

Cowels now knows what she wants to do, which is to become a physician's assistant. She figures she could triple her current income waiting tables and manage the $2,000-a-month payments she should be making to pay off her loans.

But she's not sure how she would pay for two more years of school and still cover even the much-reduced payments she's required to make on her loans. Her largest debt is a private student loan for $160,000, which has accrued $60,000 in interest so far.

"I've used up all my forbearance and deferments. I'm on a graduate repayment schedule, paying half of what I should, and that's $1,000 a month," Cowels said. "I'm stuck."

Stories like Cowels' cause some to condemn all student loans as bad debt. Writer Mary Pilon recently took it a step further: She wrote in The Wall Street Journal that "student loans are one of the most toxic debts."

Not quite.

Only some student loans are toxic

Credit card debt, payday advances and pawnshop loans are examples of toxic debt. You're paying for nothing, in essence, except for the privilege of having your financial security eroded.

Though any debt in excess can be toxic, as we've learned in the wake of the mortgage meltdown, student loan debt actually can help people get ahead by qualifying them for jobs that enhance their lifetime incomes.

The problem is that too many people don't make a clear enough distinction between federal student loans, which usually are good debt, and private student loans, which often aren't.

The key differences:

  • Interest rates. Federal student loan rates are generally fixed at 6.8% for unsubsidized Stafford loans and 5.6% for subsidized loans (although subsidized rates are scheduled to drop to 3.4% by 2011). Private student loan rates currently average 11% to 12%, and they're variable, which means their rates are likely to march higher. Furthermore, most students don't know the rate they'll get on a private loan until after they apply. Private student lenders aren't required to disclose the costs of the loan in advance, which makes it virtually impossible to shop for the best deals.
  • Amounts. To be prudent, most students should limit their total student loan debts to no more than what they expect to make the first year out of school. Students typically can't borrow more than $31,000 in federal Stafford loans for an undergraduate degree, so overdosing on this kind of debt is tough. There's no real limit on how much private student loan debt you can take on, however.
  • Repayment options. Federal student loans come with repayment options for almost every budget. You can opt for graduated payments that start small and rise over time, extended payments if you need more time to pay back your loans, or plans that base your payments on your income. You can get deferrals or forbearance if you get laid off or suffer other economic setbacks. Private student loan repayment plans are much less flexible.
  • Forgiveness. If you work in a public-service job and make payments for 10 years, the remainder of your federal student loan debts can be forgiven. Even if you're not in public service, there's a limit to your financial servitude: Any remaining balance is forgiven after 25 years of payments. Private student lenders aren't so forgiving. In fact, they're not forgiving at all.

That leads me to one thing federal and private student loans have in common: Both are extremely hard to erase in bankruptcy court.

Student loans are forever

To get out from under student loan debt, you basically have to prove not only that you can't pay your loans now but that you have no hope of paying them in the future, bankruptcy attorneys say. So if you're totally and permanently disabled, you can get your loans erased. Otherwise, you're usually stuck with them, although in cases of serious hardship you may get some fees or interest knocked off.

Federal student loans got this special status in bankruptcy court in 1998. In 2005, private lenders persuaded Congress to extend the same protection to their debt -- even though private loans don't involve government guarantees or taxpayer subsidies, which was the rationale for making federal student debts hard to discharge in bankruptcy.

Lenders who make private student loans know they've got borrowers in a corner. After allowing teenagers to sign up for life-altering amounts of debt -- amounts that often bear no relation to what the student is expected to earn after graduation -- private lenders know they can pursue borrowers for the rest of those lives to get paid back.

Congress was worried enough about lenders taking advantage of college students that it made credit cards harder to get for people under 21. But it's put no similar protections in place for kids seeking student loans. So while a college student may no longer be able to get a $500-limit credit card, he or she can still take on hundreds of thousands of dollars of unshakable student loan debt.

In "4 fixes for the student loan trap," I outlined the changes I think need to be made, including boosting federal student loan limits, requiring students to exhaust federal loans before applying for private loans and giving bankruptcy courts the power to modify private loans.

But the most important change needs to come in how students and parents view education loans. If they don't understand the differences between federal and private student loans, and put strict limits on how much of the latter debt they take on, they may spend a lifetime regretting their ignorance.