The Risks and Dangers of a Small Student Loan

Many students have a justifiable fear of student debt. Living with student loans often means delaying buying a house, getting married, or having kids.

As our collective understanding of student loan risks has grown, many students now try to avoid student loans at all costs. This approach can pay off handsomely under the right circumstances.

Many of these students fear borrowing even a single student loan. Is a $3,000 student loan dangerous? Can $5,000 of student debt still cause a student loan nightmare?

High Default Rates on Smaller Loan Balances

If there is one scary aspect about having a smaller debt balance, it is this fact: the smaller your balance, the more likely you are to default.

The solution to this problem is not borrowing more.

The scary debt statistics for small-balance borrowers require some context. The single biggest factor impacting the default rate is whether or not the borrower graduated college. Students without a degree are three times more likely to default than graduates.

The default rate for small-balance borrowers is the highest because many have never finished school.

The lesson for those considering a small student loan: The risk level depends on whether you graduate. If your small loan won’t lead to a degree or a higher-paying job, it has major risks.

Small Student Loans as a Great Investment

The flipside to our risk assessment is for the borrowers who require a small student loan to finish school.

Your smaller student loan could be an excellent investment if you are a $3,000 tuition payment away from getting a degree.

A degree could mean a pay bump of significantly more than that $3,000 in the first year alone. As a graduate, you are much less likely to default than the small-balance borrowers who don’t finish school.

The Lesson: If the one thing separating you from graduating is a small student loan, it is often safe to borrow a smaller loan.

Student Loan Headaches that Impact all Borrowers

Even if your student loan is a good investment, you still may have to deal with some of the burdens of life with student debt.

Borrowers are often targeted for student loan scams. Additionally, repayment usually involves headaches like dealing with servicers, loan transfers, and lender errors.

In most cases, these issues amount to temporary inconveniences. However, borrowers with smaller student loans still have to endure various student loan problems.

Deciding Between Federal and Private Loans

For the vast majority of students, picking a federal student loan is an easy decision.

Federal student loans offer income-driven repayment plans to keep bills affordable. They also provide various paths to student loan forgiveness. Private lenders cannot compete with these borrower perks.

The one area where private lenders occasionally beat federal loans is on interest rates. Federal loan interest rates are set by Congress, and they also include loan origination fees. Credit-worthy borrowers can sometimes find better interest rates with a private lender.

Balancing the more forgiving federal terms against the lower interest rates on private loans is especially complicated for borrowers who only need a small loan. If you expect to repay your loan within a couple of years, chasing the lower interest rate could be very tempting.

Running the Numbers: Suppose you need a $5,000 student loan, and the federal interest rate is 5.5%, while the best private loan interest rate is 2.5%.

A 3% interest gap on a $5,000 balance means spending an extra $150 per year on interest. Do you want to save that $150 per year in interest, or would you rather have the federal perks and protections?

Avoiding a Mistake on a Small Student Loan

If you are considering a small student loan, I’d suggest having two essential items in place:

  1. Make sure you will graduate.
  2. Create a plan and a backup plan to repay your loans.

If you are in your first year of college, don’t assume you will limit your borrowing to one small student loan. You have more planning to do. Someone who is a semester or two from graduation can move forward with far more confidence.

Finally, don’t assume you will land a high-paying job or even an average salary for someone in your field. What happens if you spend six months or a year finding a job? What happens if you can’t find a job in your desired field?

If you are prepared to manage the debt even if things go poorly, it is probably safe to borrow a small student loan.

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