A Word To The Wise: Why You Don't Want To Default On A Government College Loan

The federal government is now the largest financial backer of college students. And while Pell Grants have been increased many times, the biggest chunk of all college financial aid comes from government loans -- loans that have to be paid back (mainly Stafford and PLUS loans). That holds true for both undergraduate and graduate students, according to a recent report by the Institute for Higher Education Policy (IHEP), a nonprofit organization in Washington, DC.

The good news about federal loans is that they usually provide the lowest-interest option for financing your school costs. But it's important to remember that you need to be careful about how much debt you take on. People in their 20's and 30's tend to talk so much about having a hard time paying back school loans that it's easy to get the impression that it's no big deal if you can't pay the government back. But failing to pay back your debts can have several negative consequences for you.

On The Hook
If you are already paying down a federal school loan and being financially stressed by the ongoing cost, keep in mind that if you default on the loan, you will not be able to "get rid" of it by declaring personal bankruptcy, as you can with many other types of loans. Even after a bankruptcy, you will be required to come to some arrangement with the government to get your loan paid down.

In 2010, President Obama signed legislation that, among other things, allowed some people who have already borrowed money for college to change their repayments over to an "income based repayment" plan. In simple terms, that means that what you owe is recalculated according to how much money you are earning, rather than how much money you borrowed. The size of your family is also considered in your fee calculation. In most cases, your payments will be limited to 10 per cent of your total income. You only qualify for this break, however, if your debt will take more than 15% of your earnings to pay down. As with all government programs, it's a bit complicated who qualifies for income based repayment. This break applies to those who have both guaranteed or direct loans from Uncle Sam. You'll need to contact your lender to find out if it applies to you. If you work for a nonprofit organization or a government agency, you may also qualify for what's now called "public service loan forgiveness" to retire your debt - it's a process that will take 10 years.

Beware The Long Term
Keep in mind, however, that total failure to pay back your loans can cause you real problems, both in the short and long term. To being with, the government does engage collection agencies to go after people who default on their loans. That can mean phone calls and other solicitations that apply considerable pressure on you to repay.

Becoming delinquent (60 - 120 days behind in payments) in paying a loan or defaulting outright will probably be reported to the major credit agencies. That kind of information can have a negative effect in your FICO score, which can make it either more expensive or downright impossible later on to borrow money to by a car, get a mortgage for a house or borrow for any other reason.

If you do fall behind in your payments, keep in mind that your lender, whether it's a private lender under the older "guaranteed" Stafford Loan program or the government itself under the "direct" loan program, may be willing to give you some breathing room if you are having trouble paying right now. If you tell your lender that there's a good reason why you can't pay right now, you may be given a deferment or what's called a "forbearance," two slightly different type of suspensions of payments. Be aware, however, that both of these are temporary.

Do Your Loan Homework First
Finally, if you're at the front-end of the loan process, make sure you learn what you're signing on for. It may not be as interesting as your school work, but it's important. In a report called "The Untold Story of Student Loan Borrowing," IHEP interviewed numerous people employed by schools or community organizations who frequently work with student loan borrowers who are having trouble paying back their loans. They reported that, in general, these problem borrowers did not understand they repayment options that were available to them, did not understand interest and other terms of the loans they had signed up for and were making their repayment even harder by not filling out and submitting the appropriate paperwork in time to avoid a default on their loans.

The moral: keep your debt as low as possibe because you probably will have to pay it all back, and make sure you understand your loan terms (even if you have to get help from an outside expert) before you sign on any dotted lines.