Student Loans Part 1 – Why is There a Debt Crisis?

13% of the American population has some form of student loan debt as of 2023; are you one of those roughly 45 million Americans? Are you struggling to get out from under the debt you found yourself in after graduation? You’re not alone! Before we dig in, I want to congratulate you on taking the time to seek out an education. It’s no small feat and even though you may be discouraged by the loans looming over your head, knowledge is never a bad thing to have. But let’s dive in!

There are two different types of student loans: federal and private. Federal student loans will only cover a portion of your tuition, so many borrowers end up with a mix of federal and private loans. Here’s a quick breakdown of the two types and what that can mean for you as a borrower:

Federal:

• Offered by Department of Education
• Can qualify for student loan forgiveness programs
• Can qualify for income-driven repayment plans
• Don’t usually require a credit check
• Typically have lower interest rates
• Limited on how much you can borrow
• Loan servicer is assigned automatically – you can’t choose who you pay

Private:

• Offered by private banks, credit unions, and other lenders
• Will require a credit check and often a cosigner
• No amount limits
• No loan forgiveness programs
• Typically have higher interest rates
• No opportunity to defer loans or get on a different repayment plan

At the end of the day, you will be required to pay back all private loans and they are less likely to work with your unique financial situation. Federal loans have many options for when and how much you can pay back at a time, offering more flexibility for borrowers.

Where Does the Crisis Come In?

We can blame the student loan debt crisis on two major things: rising education costs that now outweigh income, and compound interest – where interest has the potential to accrue so fast that you can’t keep up. It is important to note that federal loans do NOT use compound interest. However, there are some private lenders that do.

We can explain this even more simply by saying it this way: many students are unable to repay their student loans because education costs have risen so quickly and their income has declined.

I will do a full post later about how compound interest can be your best friend or your worst nightmare. But for now, we will cover the basics. Compound interest is interest earned on interest. For example, in a simple interest loan, you are only paying interest on the principal balance. In a compound interest scenario, you will pay interest on the principal balance AND any unpaid interest.

Here’s a diagram:

The blue line shows what you pay in principal and interest over one year with simple interest. The orange line shows what you pay over one year with compound interest. See how much faster the orange line grows? This is what can happen when your interest has interest!

For borrowers, this can spell big trouble as they’re starting life after college. Here’s how:

1. You’re unable to pay one month and are now late. A late payment will negatively impact your credit report
2. You’re unable to pay and you default, meaning you don’t pay at all. Your loan will be sent to a collection agency which will negatively impact your credit report
3. You have thousands of dollars in debt and although you’re able to make the payments, you don’t have a high income. This will affect your debt-to-income (DTI) ratio. This is the ratio that lenders use to decide how much you can take out for another loan (mortgage, car, etc.) before they think you won’t be able to pay it back.

The good news is that there are options and you CAN take control of your student loans before they get control of you! We discuss ways to get loans forgiven, manage your payments, and other ways to pay them off in Student Loans Part 2.