The biggest regret most student loan borrowers have is using their student loans for fun stuff like spring break or for what seemed like unnecessary expenses. Part of my $65,000 in student loan debt came from ordering pizza way too often. I could have borrowed less and avoided still paying off the interest on pizza. But sometimes using student loans for non-school expenses can actually help you afford to go to school.
Here are four questions you need to ask yourself before you use your student loans to pay off other debt:
1. How Is the Amount You're Allowed to Borrow for Student Loans Calculated?
Your total financial aid, including scholarships and student loans, can be awarded up to the "cost of attendance." This is a number the school calculates that includes room and board, tuition and fees, textbooks and other expenses involved in attending one academic year of college.
Thus, if you manage to pay less for any of those expenses than what's expected, you won't need to borrow that much in financial aid. Some people decide they won't take on any additional debt which they don't immediately need for school, while others opt to use that "extra" money to pay off higher interest debt such as credit cards.
When you apply for financial aid, you'll have to fill out a form called the Free Application for Federal Financial Aid, a.k.a. FAFSA. Read this article to ensure you don't make any big FAFSA mistakes—because they can really cost you.
2. How Does Your Other Debt Affect Your Budget?
Credit card payments are due immediately while your student loan payments generally don't have to start paying them back until after you graduate. Thus if you have $100 payment on your credit card, not only does it delete $100 from your budget but you are also generally paying a much higher interest rate.
In the case of federal student loans, the current interest rate is 4.45% subsidized and unsubsidized loans for undergraduates. Credit card interest rates can be much higher—sometimes as high as 20% or even close to 30%. So, often people think it makes sense to use low-interest student loans to pay off high-interest credit cards, especially when they just don't have the cash on hand to pay off the cards. In some ways, it makes sense and it may even work to your benefit. But there are some things to consider when it comes to those interest rates.
First, it's so important to note the difference between subsidized and unsubsidized student loans. When the government subsidizes your student loans, it means they are paying the interest while you are in school at least part-time. In the case of unsubsidized student loans, you still don't have to pay while you're in school, but the interest accrues each month and rolls into the loan.
So if you use a subsidized loan to pay off your credit cards (which would be unusual because subsidized loans typically go right to the school to pay for tuition), then you've got an interest free loan for the four years you are in school. But again, that's not likely.
On the other hand, let's say you use an unsubsidized federal loan or even a private student loan to pay off $5,000 in credit card debt, and you defer payment while you are in school. At a 4.45% APR, your loan will go from $5,000 to nearly $6,000 after four years, and then you'll have to begin paying it off, all while it continues to accrue interest.
So, if you're going to use your student loans to pay off your credit cards—especially while you are still in school, and even more especially if you plan on using unsubsidized student loans to do it—be careful. You may be scoring a lower interest rate, but you could end up paying plenty in the long run.
3. How Are You Budgeting?
You don't want to pay off your credit card just to charge it back up. Thus, make sure if you do use your student loans to pay off credit cards, you don't end up with a shortfall. You need to make sure that you have enough money on hand for expenses that may occur later in the semester or year. Look at your budget carefully so you can really plan how much you are going to need when you are in school.
Be careful to avoid wishful budgeting or budgeting based on your former income. Wishful budgeting is when you create a budget based on what you wish you were spending—such as eating all your meals at home when you know you won't, underestimating how much you'll spend on clothes, and eliminating all entertainment expenses. What are the chances you'll NEVER go to a movie while in college?
You can cut back but do it within reason and cut painless items such as getting less expensive but equal car insurance. Avoid unmindful, zombie spending, spending that you do without thinking and don't necessarily enjoy.
You can also wait until the end of the semester to use money left over from student loans if you got a great deal on textbooks and use the difference between what you paid and what you thought you paid to pay down credit cards.
Once you eliminate your credit card debt, you can start borrowing less while continuing to look for new scholarships each year. Of course, you shouldn't pay off your federal student loans early if you might qualify for any form of loan forgiveness.
4. Could You Use Other Money to Pay off Credit Card Debt?
Debra Chromy, Education Finance Council President, suggests, using income from a part-time job to pay off credit card debt while using student loans for living expenses. Since student loans can cover the full cost of education and living expenses while in school, earned income can be used for paying off debt. After the debt is paid off, income can be used to reduce student loan borrowing.
Budgeting for college and paying off the loans afterward is a process that involves budgeting now and developing a game plan that considers loan payments in the future. Thinking about your overall credit and loan usage is a good start.