College Finance 101: Beware of Toxic Debt

College students appear to be frighteningly ignorant about one of the biggest risks they're likely to face in higher education: Toxic debt.

An analysis released today found that nearly two-thirds of the undergraduate students who borrowed for school took out something called "private" student loans before they had exhausted their borrowing power with federally-guaranteed student loans. That's the equivalent of saying "I could have borrowed money from Mom, but I decided to go to a loan shark instead."

Think I'm exaggerating? Here's the deal. Federal student loans currently are issued at a 6.8% fixed rate or less, depending on whether you have financial need. If you get a so-called "subsidized" federal student loan, your rate will be lower and the government will pay the interest while you're in school. That vastly cuts your cost of credit. Like Mom, the federal government also is sympathetic to your ability to repay, offering something called "income-based" repayment that almost guarantees that you won't have to pay more than you can afford when you get out of school.

If you get a private loan, the upfront fees can reach 10% and your interest rate is likely to be in the double-digits and adjustable, changing as frequently as once a month. Generally speaking, there's no "cap" on these loans, meaning that there's no limit on how high the cost of your credit could soar if interest rates rise. The highest rates are charged to those who can least afford the debt, said Lauren Asher, president of The Institute for College Access & Success. TICAS's affiliate, the Project on Student Debt, conducted the analysis.

Using private loans is a lot like using credit cards to finance college, Asher added. But there's one compelling difference. You can discharge credit card debt in bankruptcy. Student loan debt can haunt you for the rest of your life.

Private loans historically have been issued with far fewer interest disclosures than other types of debt, including mortgages and credit cards. A law passed last year will increase disclosure as of next February, but final rules issued by the Federal Reserve Board fall short of fully protecting the unsophisticated borrowers who take out student debt, according to TICAS. Their analysis of the Fed rules spell out a variety of areas where they believe students are still at risk.

The moral of this story: Study up on student debt, or risk the toughest lesson of your life--being haunted by toxic debt forever.