What is an Education Loan?
An education loan refers to a type of loan that is borrowed by students to finance their expenses related to post-secondary or higher education. Education loans can be used to pay for tuition fees, basic living expenses, as well as books and supplies necessary during the education period. Compared with other types of loans, education loans usually carry lower interest rates, and the repayments are typically deferred until students earn their degrees.
The education loan policies vary in different countries. In the U.S., students can obtain education loans either from the federal government or from private lenders. Education loans cannot be discharged by claiming bankruptcy unless the borrower can demonstrate that the repayments will lead to “undue hardship.” Hence, the potential losses of lenders on education loans are very limited.
- Education loans are borrowed by students to finance their expenses related to post-secondary or higher education, including tuition fees, living expenses, as well as books and supplies.
- There are two types of education loans in the U.S. – federal education loans and private education loans.
- Private education loans require a credit check and charge higher interests, whereas federal education loans do not.
Types of Education Loans
1. Federal Education Loans
In the U.S., federal education loans make up the majority of education loans. Borrowers of education loans typically seek financing from the federal government first. The applicant information required to facilitate the application process varies in different cases, depending on the applicants’ status.
The amount of the loan that a borrower can receive usually depends on one’s state of residence, family income, parental dependency, as well as tuition fees and living expenses. A credit check is not necessary for the application process.
Federal education loans can be further categorized into direct subsidized loans, direct unsubsidized loans, and direct consolidation loans.
- Direct subsidized loans can be availed by undergraduate students only. Applicants need to demonstrate financial need in order to be eligible.
- Direct unsubsidized loans can be availed by both undergraduate and graduate students without requiring financial need demonstration. Both types can be converted into consolidation loans.
- Direct consolidation loans allow the borrower to combine several federal education loans into one. It charges interests based on the average rate of each loan.
2. Private Education Loans
Private lenders of education loans typically follow a traditional application process. They also ask for higher interest rates than the federal government. Thus, students usually go for private education loans only after running out of their maximum amounts available for federal loans.
The private education loan providers include state-affiliated non-profit lenders and institutional lenders, such as universities. A credit check is usually required as a part of the application process. If a loan application is approved, the school that the borrower attends will receive the funds first to cover any pending bills. Then, the borrower will receive the rest of the funds.
Income-Based Repayment (IBR) Plan
The income-based repayment (IBR) plan allows borrowers to make repayments based on their income. The IBR program is offered by the federal government as an alternative to settle loans. It is not available for private education loans, which makes federal loans more favorable to borrowers.
The IBR plan caps repayments at 10% of the borrower’s income. If the interest that should be paid exceeds 10% of the borrower’s income, the exceeded parts will be deferred and added up to the balance owed. If the education loan cannot be fully repaid after a certain period, the remaining balance of the loan will be forgiven. The period is ten years for the borrowers working in the public sector or 25 years for the ones working in the private sector.
Criticism Against Education Loans
The U.S. education loan system remains a controversial matter for many. Without a credit check, the interest rate of federal education loans is not adjusted for credit risks. It results in an inefficient allocation of resources in higher education and high default rates.
Additionally, the debt level’s been high and keeps rising. The amounts of education loans owed by students exceed the amounts owed for their credit cards almost all the time. The combination of a high debt level and default rates creates burdens to taxpayers in general.
The IBR plan is criticized for moral hazard and adverse selection, as it encourages borrowers to borrow as much as possible with loan terms as long as possible. The program is most beneficial to the ones with the highest debt-to-income ratio, which significantly increases the possibility of default.
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