Is using student loan money to pay off debt while in school legal, practical, or sensible?

It is difficult to earn an income while studying for a college or graduate degree. Meanwhile, the high spending causes debt to pile up quickly.

It may be tempting to transfer money from one lender to pay off another – especially when you are past due on an existing account. Answer three basics questions before taking this step.

  • Legality: Did the existing debt came from education-related expenses?
  • Practicality: Is there enough leftover money after paying the school?
  • Sensibility: Do the long-term benefits outweigh the drawbacks?

Legal Uses of Excess Student Loan Money

Many young adults ask whether it is legal to use excess student loan money for anything – including paying off debt. The Office of Federal Student Aid states on its website, “All loan funds must be used for your education expenses.”1

However, finding a precise legal definition qualifying charges is difficult. In addition, borrowing limits relative to your financial need place practical restrictions.

Educational Expenses

It should be safe to use student loans to pay off debts related to education expenses – if you have proper documentation and can be certain of the rules. Two federal government laws offer legal definitions for education-related expenses.2

  1. Higher Education Act of 1965 (HEA) sets out the cost of attendance calculations
  2. Internal Revenue Code of 1986 (IRC) codifies tax benefits

These two laws combine to create twelve unique but overlapping definitions. This unnecessary complexity makes it impossible to provide a blanket answer. Below are qualifying and non-qualifying charges for full-time on-campus attendees.

QualifyingQuestionableNon-Qualifying
Tuition and feesMortgage down paymentCosmetic surgery
Required suppliesHouse purchasePlastic surgery
TextbooksAuto purchaseBreast implants
TransportationReal estate investments
Dependent careStock market investments
Disability-relatedVacation travel
Loan Fees
Miscellaneous personal
First professional credentials
Room and board

Borrowing Limits

Even if you could legally use student loans for just about anything, borrowing limits make it impractical and costlier pay down other debts. You may not have a large amount of excess money to play with. Plus, the interest rates may be higher.

Federal Limits

Federal student loan borrowing limits often fall well short of the average 4-year total cost of attendance at many colleges.

    • In-State Public University: $101,160
    • Private College: $203,6003

The federal government caps the principal amount for subsidized (lower interest) and unsubsidized (higher interest rate) loans for undergraduates.

DependentIndependent
Subsidized$23,000$23,000
4-year Aggregate$31,000$57,000

Private Limits

Private student loan borrowing limits and fees work differently. The limits are often much larger and the interest rates are often higher (no subsidies). Private lenders may approve a principal amount up to the Expected Family Contribution (EFC) at your college of choice – provided you meet their underwriting standards.

  • The credit score of the primary borrower is sometimes a consideration. Avoiding delinquencies and revolving balances are keys to qualifying.
  • Most undergraduates require a co-signer in order to qualify. In other words, one or both parents agree to make payments on your behalf if you are unable to after graduation.

Financial Need

College financial aid offices work under government rules to calculate your Expected Family Contribution (EFC). The EFC caps the amount of money you can borrow. The office shares this number with direct and private lenders.

Expected Family Contribution (EFC) = Cost of Attendance – Financial Need

Direct and private lenders disburse funds directly to your college financial aid office or bursar. The bursar subtracts their direct costs for tuition, fees, on-campus dormitories, meal plans, etc. for each semester. They then transfer the remaining money – if any – to the attendee’s bank account.

These leftover amounts can be small (living on-campus with a full meal plan) or large (off-campus apartments or commuters). Obviously, you must borrow enough to have extra funding to retire any eligible debts.

Paying Off Debt While In School

Using student loans to pay off debt while in school is sometimes a viable an option. You would need to have excess funding and the ability to document that the obligations resulted from legitimate education-related expenses. In addition, it should make sense financially.

Converting debt to a student loan sometimes works to your advantage. Other times it does not.

Credit Card Debt

Is it illegal to use student loans to pay off credit card debt with any excess funding?

  • The answer is clearly “NO” if you ran up your revolving balances by charging education-related expenses to your account.
  • Credit cards are a convenient payment option for eligible items such as textbooks, transportation, dependent care, and meals.
  • The “miscellaneous personal” spending category is vague and can include charges for a variety of items such as furniture, utilities, entertainment, and more.

Transferring these revolving balances is a legitimate use of the borrowed money. However, this method has pros and cons.

Advantages

  • People with bad credit qualify for federal loans
  • You can defer payment while still attending school
  • Federal programs have flexible repayment options
  • Interest rates may be lower
  • The payments may be tax deductible
  • Paying off credit cards boosts your credit score
    • Improves payment history on past-due balances
    • Reduces the revolving utilization ratio

Disadvantages

  • It is much harder to discharge student loan debt in bankruptcy
  • The interest has more time to accumulate
    • Accrues during deferment
    • 10 to 20-year repayment period
  • Cosigners become responsible if you default on private loans

Automobile

Using student loans to pay off a car could be a legitimate use of the money for people living off-campus or commuting from a distance. The Higher Education Act specifically lists transportation as an education-related expense. Keep a written record of the miles driven each day just in case.

Retiring auto debt while in school has similar pros and cons. You can skip making payments until after graduation, but face greater difficulties if you become delinquent in the future.

Other Student Loans

Using new student loans to pay off other older student loan debt rarely makes sense. You are paying more in fees and getting little in return.

  • Origination fees on new loans add to borrowing costs. Lenders take a percentage of the proceeds upfront but require you to repay the entire principal with interest over time.
  • Deferring payment while in school on older existing loans is an option for both federal and private contracts. Avoid having the lender take an additional origination fee with this alternative.

Sources:

  1. The office of Federal Student Aid
  2. Education-Related Expenses
  3. Average Cost of College
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