The Not-Smart Option: Why Sallie Mae’s New Graduate Loan Program is a Scam

Sallie Mae announced this week that they will be offering a new and more attractively priced Smart Option loan product focused on competing directly with Federal Grad PLUS loans for graduate students.  Sallie Mae argues that, given historically low interest rates, they can offer competitive lending products that actually cost the borrower less than what the Department of Education offers.  This assertion is an outright lie aimed at tricking graduate students into taking much riskier loans that will be much more expensive for the average borrower.  In this post, we will outline why absolutely nobody should take out a Sallie Mae private loan instead of a Direct Grad PLUS loan.

The figure above outlines the major loan characteristics for the Grad PLUS loans and for the lowest and highest tiers of Sallie Mae’s new graduate loan product.  Clearly, the highest priced Sallie Mae product is out rightly more expensive than the Grad PLUS product, so there is absolutely no reason to believe borrowers would benefit from selecting the “Smart Option” in this case.  However, some borrowers might be tempted to accept the 5.75% fixed rate Sallie Mae loan instead of taking the 7.90% Grad PLUS loan.  There is a serious risk to this strategy: the borrower would be foregoing income based repayment and loan forgiveness programs only offered by the Department of Education and would likely need a parental cosigner on the loans who would assume equal financial responsibility for their repayment.  Given these risks, I conclude that the “Smart Option” is universally the wrong option for graduate borrowers; let me explain why.

Both Sallie Mae and Grad PLUS loans are readily prepayable at no expense to the borrower.  That means that every borrower has the right to refinance their existing student loans if they can find a lender who will offer them a more competitive rate.  So, when a graduate student is comparing loan products to fund their education they should not be comparing the nominal, contractual payment schedule, but instead they should be comparing the most advantageous repayment strategies.  Notably, a borrower can take out Grad PLUS loans to fund their education and if they graduate and attain high paying employment after graduation, then they can refinance their Grad PLUS loans into lower interest rate private loans in order to capture their improved credit quality.  However, if they don’t graduate or graduate but struggle to find high paying employment (or choose to start their own business or work for a non-profit), then they can keep their Grad PLUS loans and utilize the borrower benefits unique to that loan product.  It is all reward and no risk: Why take a private loan as a student when you can just wait and refinance into a private loan after graduation?  The only cost for the pursuing this strategy is the upfront origination fee charged by the Department of Education and the two years of interest expenses that accrue while the borrower is in school.  For a closer look, let’s examine the two competing strategies by comparing the financial outcomes for an MBA candidate who is taking out $30,000 for each of her two years of graduate study.

Sallie Mae “Smart Option” Strategy

In this scenario, we assume that the borrower opts to take the 5.75% Smart Option loan to fund the full cost of her education.  In this case, she has taken out $60,000 in principal ($30,000 each year with no origination fees) at a fixed interest rate of 5.75% and a repayment term of 15 years.  Let’s further assume that she successfully graduates and achieves her dream job on Wall Street and is making six figures from day one.  This is a great outcome and here risk of default is almost zero.

Grad PLUS with Private Refinancing Post Graduation

In this scenario, we assume that the borrower opts to take the 7.90% Grad PLUS loan to fund the full cost of her education.  In this case, she has taken out $62,400 in principal ($30,000 each year with a 4% origination fee) at a fixed interest rate of 7.90% and a repayment term of 30 years.  Let’s keep our Wall Street dream job assumption and assume that she uses Prime Student Loan to refinance her student loans immediately after graduation at a 5.75% interest rate on a 15 year term (identical to the Smart Option in the previous scenario).

The chart above summarizes the outcomes for each scenario.  What we see is that the “Smart Option” does, in fact, cost the borrower less in this ideal scenario.  However, it only amounts to $478 in annual savings or roughly one percent in annualized borrowing costs.  But what is the borrower sacrificing for this incremental gain?  The borrower loses ALL the generous borrower protections provided by the Department of Education and dramatically reduces their financial flexibility. 

What would happen if the borrower had a family crisis and had to suspend their studies?  If they took out Grad PLUS loans the impact would be minimal as they could opt into an income based repayment plan until they completed their studies or returned to a higher paying position.  If they took the “Smart Option” they may qualify for temporary forbearance, but ultimately they would be required to start making full payments on those loans with the threat of default and a 25% fee. 

What if the borrower wishes to start their own business or pursue a lower paying course of employment, such as a non-profit?  If they took out Grad PLUS loans the impact would again be minimal as they could take advantage of income based repayment while they pursued their passion.  If they took the “Smart Option” then they would be forced to pursue only higher paying employment opportunities in order to support their mandatory and inflexible student loan payments. 

What if the borrower graduates into a recession or loses their job early in their repayment schedule?  Again, not a problem if they took out Grad PLUS loans.  However, if they took the “Smart Option” then they would be at great risk of loan default, which carries enormous fees, ruins their (and their cosigner’s) credit, and is almost impossible to discharge in bankruptcy. 

The bottom line is the “Smart Option” is not smart at all.  The borrower is taking an enormous financial risk and gambling their own and potentially their cosigner’s financial wellbeing in exchange for a maximum savings of $478 a year.  That’s less than half of what the average MBA graduate spends at Starbucks each year.  Shame on Sallie Mae for trying to fleece students even more than they already are, but shame on any student or parental cosigner who accepts this financial risk without understanding the tradeoff.  So, take our advice on this one: don't buy what Sallie Mae is selling, take the Grad PLUS loan and just opt for a regular coffee at Starbucks instead of the mocha latte.