Student Loan Options

What Type of Student Loan Should I Get?

For a lot of families, student loans are what makes college possible, and if you’re going to borrow, you need to be able to make good decisions about it. Because the big problem with our system isn’t that education loans are available; it’s that nothing and no one is going to stop you or your student from taking on more student loan debt than you can handle, so you need to manage this process yourself. 

I always recommend that if you’re going to borrow for college, whether the parents or the student will be borrowing, you should start with the federal direct student loan. It has the lowest fees and lowest interest rates of any of the federal loans—and usually of any private loans, too—and has all the federal loan protections like in-school deferrals, income-based repayment plans, deferment and forbearance in times of financial hardship and fixed interest rates. And in case you were not aware, federal direct education loans were the only loans that were suspended with no payments and no interest accruing during the pandemic. 

The downside of the direct student loan is that you can’t borrow much. First year students can borrow $5,500, second-years, $6,500, and then $7,500 per year after that. Often parents say, “well, I can borrow more from parent PLUS loans so why would I borrow sooner rather than wait until my student’s last years and just take bigger PLUS loans?” The reason is, the interest rate is so much higher on the parent PLUS loan that it’s cheaper to take the direct student loan every year, even if interest accrues for four years. Student loan interest rates are a fixed markup from the 10 year Treasury in May of every year. The markup on the parent PLUS loan is 2.55% higher than on the direct student loan. 

And honestly it’s not necessarily a bad thing that you can’t borrow more. A student who takes out the full direct student loan every year for four years will graduate owing about $29,000 including the interest that’s accrued and will pay around $300 per month for 10 years to pay it off in full. That’s a reasonable investment in college. And in fact, less than 10% of students who borrow from the direct student loan program and graduate from college are behind on their student loans. 

If you take out the direct student loan, the student is the named borrower on the loan, no matter who makes the payments. This can be good for two reasons:

1. making the payments will help them to establish credit, and

2. it’s more likely that their income will fall in the range where they can deduct the interest on their taxes. And that deduction is worth about one monthly payment a year.

The Four Types of Federal Student Loans:

1. Direct subsidized loans are loans for undergraduates. The subsidy refers to the treatment of interest during the school years: no interest accrues on the loan while the student remains enrolled at least half time, for the six month grace period following graduation and during deferment periods. Subsidized loans are awarded on the basis of need. These loans have an annual cap of $3,500 for the first year, $4,500 for the second year, and $5,500 for the third year and beyond.

2. Direct unsubsidized loans are also for undergraduates; these do not receive the interest subsidy so interest begins to accrue as soon as the loan is disbursed. Loan limits are $5,500 for the first year, $6,500 for the second year, and $7,500 for subsequent years. (Students receiving subsidized loans can borrow additional unsubsidized funds up to the aggregate annual limit, meaning a first year student with $3,500 in subsidized loans could borrow an additional $2,000 in unsubsidized loans.) Independent students or those whose parents do not qualify for PLUS loans can borrow an additional $4,000 in each of the first two years and $5,000 in subsequent years.

3. Direct PLUS loans are for parents or graduate students. There is a cap on loan amounts for graduate students of about $21,000 annually. But parents can borrow up to their student’s full cost of attendance minus any financial aid.
   Parent PLUS Loans are federal education loans that parents can take out to finance their children’s education. Parents can borrow more than students– up to the student’s full Cost of Attendance annually.
   Parent PLUS loans are less favorable than direct student loans:

   • Interest rates are always 2.55% higher than the rates on direct student loans. That means that you would pay about $1,000 more in interest during repayment if you took out a $5,500 parent PLUS loan instead of a direct student loan. The interest rate for the 2021-22 school year is 6.284%, which is higher than just about any other type of loan.

   • Parent PLUS loans have an origination fee of 4.228%. So every $10,000 you borrow costs $422.80 in origination fees. This fee is simply added to the loan balance.

   • Parent PLUS loans allow for in-school payment deferral but no interest subsidy is offered.

   • The only option to transfer a parent PLUS loan to the student post-graduation is for the student to qualify for a different loan, take out that loan and use it to repay the parent PLUS loan.

   • While any student can take out a Direct Student loan, Parent PLUS loans can be denied on the basis of credit. (Students whose parents are denied parent PLUS loans can take out larger Direct Student loans, however.)

   Parent PLUS loans, like all federal direct education loans, have a unique benefit when compared with other loans: they are non-recourse, meaning that if the borrower dies or becomes disabled, the loan is discharged with no one else needing to assume liability for it. That can make for some instances where parent PLUS loans are a good option, such as an older parent. For example, a 70-year-old parent who might have a 15 year life expectancy following the student’s college graduation could borrow PLUS loans, then go into the 30-year repayment plan and have the balance forgiven upon their death.

4. Direct consolidation loans are loans that combine multiple federal loans into a single loan. These are often used by graduates needing to refinance older federal loans into newer federal loan types in order to qualify for income-driven repayment plans.

Federal direct student loans are a unique type of loan: the federal government is lending to an individual with (typically) no credit history. Unlike a private lender who qualifies the borrower through a risk-assessment process, the federal government is assuming the risk of non-payment. Visit the the Interest Rates and Fees for Federal Student Loans page on the the StudentAid.gov website for current interest rates and official details.

Benefits of Federal Student Loans

For students who are going to borrow to attend college, the federal programs are their best option, and limiting borrowing to the federal direct student loans will leave them with an affordable loan payment when they graduate. The total amount a student can borrow over 4 years is $27,000. Depending on interest rates, this translates to a monthly payment of around $300-$350 for 10 years. One potential downside of federal loans, especially parent and grad PLUS loans: you cannot refinance to a lower interest rate in the federal loan program—this is currently a non-issue given the recent trend of historically low interest rates.

The federal loan programs have numerous benefits:

• Fixed interest rates for the life of the loan.

• No cosigner or credit approval required for student loans.

• Deferral while in school. This is automatic for student loans and optional for parent loans.

• Options for deferring payments in times of financial hardship. (Note that interest continues to accrue.)

• Eligibility for income-driven repayment programs and, for those in qualifying jobs, public service loan forgiveness.

• In addition, only federal student loans were suspended with no payments and no interest accruing during the pandemic. This has now been extended through January 31, 2022.

In addition, while federal loans can be refinanced into private loans, private loans cannot be refinanced to federal loans. Some graduates who are established in their careers and less reliant on the federal loan protections may find that they can refinance federal loans to private loans to get lower interest rates. However, the reverse is never true: private loans will remain private loans until they are paid off.

What should you do if the direct student loan isn’t enough? Honestly, you should think about why you want to attend a college that costs more than you can afford. But sometimes the issue is just short-term cash flow.

Private Student Loan Options

Private Education Loans 

https://thecollegefinanciallady.com/2021/07/21/borrowing-outside-federal-loan-programs/

Private education loans are offered by many lenders and financial institutions. The terms vary by lender; a few key differentiators between federal and private loans are:

• Private student loans require a creditworthy cosigner, unlike federal direct student loans, meaning that the cosigner is equally responsible for the loan.

• Interest rates may be variable instead of fixed and refinancing to lower interest rates may be offered.

• Repayment options may be quoted on different terms than federal loans, which are quoted on 10- or 30-year repayment schedules.

• Most offer in-school deferment with interest accruing.

• Some lenders may offer limited hardship provisions.

• Private loans cannot be refinanced into federal loans, although federal loans can be refinanced to private.

• New private loans issued after 2018 can be discharged in the event of the death of the student borrower.

Interest paid on any education loan– federal or private, parent or student– up to $2,500 is tax deductible for qualifying taxpayers. The deduction phases out at AGI of $70,000-$85,000 (single/head of household) or $140,000-$170,000 (married filing joint), and is an above-the-line deduction meaning you can claim it even if you don’t itemize. Only the named borrower can take the deduction, regardless of who’s making the payments. That means that parents paying off a direct student loan on behalf of the student don’t get the interest deduction, but the student would.

There are countless other types of loans available. One important consideration with any non-education loan is that you will need to begin making payments right away. This can ultimately result in more borrowing because as you direct cash flow towards loan payments, it’s not available for other expenses which leads to larger loans in subsequent years. Here are some of the most common types of loans families ask about:

Home Equity Loan for College

In some cases these can be a reasonable means of borrowing. Interest rates are generally cheaper than for parent PLUS loans and it’s possible to make interest-only payments in the initial years of the loan. HOWEVER:

• HELOCs have variable interest rates so you could end up with a much more expensive loan than anticipated

• HELOCs typically have a limited withdrawal period– usually 10 years. If you have an existing HELOC, you might not be able to continue withdrawing from it through the college years.

• DANGER WILL ROBINSON: The collateral for a HELOC is your home. That means if you default on your HELOC, the lender could foreclose on your house.

• Interest on the portion of your HELOC used for anything other than a home purchase or renovation is not tax deductible.

401(k) Loans

One place you should never borrow for college is from your 401k. The obvious reason for this is, you have to start making  payments right away and the maximum loan term is 5 years, so if the reason you’re borrowing is that you don’t have money, a 401k loan isn’t going to help. The other reason is that if you leave your job before repaying the loan, the entire outstanding balance needs to be repaid within 60 days or it’s treated as a taxable distribution.

Personal Loans

These are a lot like student loans but without the benefits of student loans: interest isn’t deductible and you can’t defer payments while in school.You’ll also need to pass a credit check for your loan applications.

Best Types of Student Loans

Your starting point for borrowing should be the federal direct student loan, regardless of whether the parent or the student intends to be responsible for repayment. That’s because those loans have the lowest interest rates and most favorable repayment options, including hardship provisions. Once you fill out the Free Application for Federal Student Aid, or FAFSA, you’ll know how much you are eligible to borrow.

We usually recommend that families needing to borrow more than that start with the Parent PLUS loan even though there may be cheaper private loan options. That’s because you can always refinance a federal loan into a private loan, but you can’t go the other direction. Until you know how much you’re going to borrow total– over four years or longer with multiple students– it can be very beneficial to have the federal provisions available to you. At that point, you know what your total balance is and are in a better position to shop around for the best repayment option including refinancing.

Need another reason to start with federal loans? Only federal direct loans were suspended with no interest accruing during the pandemic and through the end of September, 2021. Private loans still required payments.

Sallie Mae’s How America Pays for College

According to the report, about 1/3 of students and 1/5 of parents borrow to pay for college each year, with borrowed money covering about 21% of the total cost of college. The report also showed that while federal student loans were the most common form of borrowing, about 10% of students used private loans as well. That’s too bad, because the federal loan programs have some protections that can be really valuable during school and for recent graduates entering the workforce.