Why college loans are the worst debt

As long as I can remember, savants in personal finance had one iron-clad guideline about debt: Know the difference between “good” debt and “bad” debt.

“Good” debt was mostly in the form of mortgages because you could build equity through home ownership. Better yet, you can deduct a portion of the interest if you itemize deductions on your federal taxes.

Then there’s bad debt such as credit card and installment loan finance charges, which can’t be deducted and can lead you into a financial black hole.

But the worst debt of all is probably college loans, particularly if they don’t lead to a degree or gainful employment.  

How is college debt somehow worse than noxious credit card debt? For most people, it’s nondeductible. Even worse, except in extreme circumstances, you can’t get rid of it even in bankruptcy. It will stay with most people for decades if they don’t pay it off -- even into retirement.

The 44 million Americans who have college loans are also carrying the kind of burden that gets worse over time. It prevents them from buying homes and settling down. When they go into default, they get burned even more by a damaged credit rating, which puts low-cost credit out of reach for those saddled with loans and other debts.

According to a new report by the progressive think tank Demos, “student debt is particularly damaging for individuals who struggle to repay their loans. Delinquent borrowers are saddled with fees, penalties and rapidly accumulating interest; borrowers who default on their loans face ruined credit and a debt often several times their original loan balance.”

Robert Hiltonsmith, who authored the Demos report, noted: “The majority of people struggling to pay back their college loans have relatively small amounts of debt; half owe less than $16,400.”

“This belies the common media portrayal of struggling borrowers as carrying excessive amounts of debt beyond the average, and brings into question whether a higher education system financed primarily by debt is putting undue risk on students trying to build skills and climb the economic ladder,” Hiltonsmith said.

Relatively small debts can cause big problems, he found. “There is no ‘safe’ amount of student debt: Borrowers with small balances struggle to repay them at the same rate as borrowers with higher balances.”

Not surprisingly, lower-income borrowers and students of color were more likely to default on their loans. And the size of the loan was unrelated to the default rate, the study reported. One-third of those in default owed less than $10,000.

Despite President Donald Trump’s campaign call to privatize the college loan business, which is dominated by the federal loan program, there’s little relief in sight for student borrowers. A moratorium on college debt would help enormously. At the very least, the government should stop charging interest on these loans.

Would it make sense to boost the federal tax write-off for student loan interest? That’s unlikely since it will do little to reduce the actual cost of college, although the after-tax cost of financing will drop somewhat.

At present, you can write off $2,500 in loan interest -- if you meet certain income qualifications. You can’t write off interest if you’re married and filing separately, and you lose the write-off if your adjusted income is more than $80,000 for single filers and more than $160,000 for joint returns. Other rules apply as well.

Still, the true cost of college looms large if taking on debt doesn’t lead to a decent-paying job, which is increasingly harder to find in the age of automation, outsourcing and globalization.

Reasonable solutions to trim college costs include boosting grant aid to public college students to eliminate loans, allowing graduates to discharge college loans in bankruptcy and increasing subsidies to state schools to help them reduce tuition. But I would give these proposals low odds of passage in the current political climate.

Demos’ “Affordable College Compact Plan,” which it published nearly three years ago, has several more sensible ideas.

In the interim, the best way to avoid college debt involves a careful planning strategy. Consider low-cost, debt-free degrees that involve community and commuter colleges. Insist on institutions that provide grants over loans. Avoid for-profit colleges.

More important, do the math that shows you how much taking on college debt will cost you over time. How much will your monthly loan payment be, including principal and interest, when you graduate?

When doing your financing calculation -- you’ll find a number of free calculators online -- keep in mind that you also have to project your estimated post-graduate salary along with your debt repayments.

Want to get an idea of how much you’ll be making when you graduate? Every college should supply you with this information. You can also check PayScale’s surveys, which track earnings by degree.

If you can’t handle a monthly loan bill without squeezing your earnings to nothing, then you need to make a decision. Will your college debt be ultimately good or bad? This exercise isn’t only good personal finance practice for any debt you take on, it should be an essential part of your college planning journey.

Note: This story was updated to correct the conditions under which you’re allowed to deduct up to $2,500 in interest, according to IRS rules.

  • John Wasik

    John Wasik is the author of The Debt-Free Degree and 15 other books. He writes and speaks regularly on personal finance issues throughout North America.