Don't Ever Take Out a Private Student Loan

As the price of college keeps growing and the interest rates stay low, it might be tempting to consider a private student loan.
As the price of college keeps growing and the interest rates stay low, it might be tempting to consider a private student loan.

FoxBusiness (NWS) offers a list of "six things to keep in mind when considering getting a private loan to pay for high [sic] education."

But there's one thing reporter Hope Holland left off the list: Don't ever do it. Private student loans have variable interest rates, which make them ticking time bombs of mass destruction. They're just like adjustable-rate mortgages except without caps on how much they can rise each year and without any collateral to be sold off in case you realize you can't afford the loan when interest rates rise. Oh, and you also can't discharge student loans in bankruptcy.

Here's why private student loans are so dangerous: People are borrowing five- and even six-figure sums of money with no plan to start paying the loans back for another four years. No one knows what interest rates will be in four years, and that means they're borrowing an amount of money with no idea how much they'll have to pay back when they graduate. Simply hoping that interest rates don't rise from their historically low levels over the next half decade isn't a good financial plan.

How Bad Could It Be?

Let's use real numbers to show just how badly this could work out. For its school-certified private student loans, Chase (JPM) currently offers an interest rate of anywhere from 3.5% to 10% above the three-month London Interbank Offered Rate, depending on the credit score(s) of the borrower and the cosigner, if there is one. (The London Interbank Offered Rate, also known as the Libor, is a standard financial index that represents the wholesale interest rate at which banks lend money to each other in London, and it's often used to set loan rates.)

The three-month Libor rate currently hangs right at 0.53%, but as recently as 2007, it hit 5.62%. Go back to September of 1989 and it reached 9.125%.

If the Libor climbs higher by the time you -- or your student -- graduate, what effect will that have on the loan payments? Assuming a private student loan of $35,000 at a rate of 5% above the Libor rate and a 10-year repayment plan:

  • If Libor stays at 0.54%, the interest rate will stay at 5.54%, for a monthly payment of $380.54.

  • If Libor rises to 5.62%, the interest rate will reach 11.16%, for a monthly payment of $485.30.

  • If Libor grows to 9.125%, the interest rate will equal 14.125%, for a monthly payment of $546.07.

What if there's some kind of global financial crisis and the Libor soars even higher? Unlike an adjustable-rate mortgage, which caps the amount the interest rate can rise each year, private student loans almost never have a cap.

Could Be Even Worse

How likely is it that the Libor will soar? I don't know and neither do you. Nobody has any business taking out a massive unsecured loan that's tied to such a volatile rate. Many banks are advertising these loans with the current extremely low interest rate in bold letters, but that's an almost meaningless number. By the time you start making payments, the rate could be a lot higher.

I've made no secret of the fact that I hate student loans in general, and that ordinary, middle-class families can and must find ways to avoid them. But once you get into the world of private student loans, you really are entering the realm of stupid on a whole new scale: limitless risk with limited options if rates do, in fact, rise.

In the FoxBusiness story, Holland does recommend trying every other financial-aid option before considering a private student loan. Still, advising people on the smartest way to take out a private student loan is like discussing the safest way to inhale asbestos.

Unless you hate your kid, do everything in your power to discourage him or her from attending a college that would require a private student loan. And if you're a student considering a private student loan, don't do it. The notion that high-school seniors should bet their financial solvency on fluctuations in the Libor is absolutely insane, and it's irresponsible for anyone -- financial aid officers, bankers or journalists -- to ever suggest that they should.