Your client’s student has made a college choice. They have accounted for all their savings, cash flow, scholarship, and grant options. And they discover they still haven’t covered all the costs. They have a funding gap. Loans will have to be a part of the solution.
They are definitely not alone. Loans are part of the equation for nearly 7 out of 10 students.
Be sure to use student federal loans first.
Now, say they’ve also maxed out the federal student loan funds available. Students have a certain dollar amount in federal loans they can borrow each year: $5,500 freshmen year, $6,500 sophomore year, $7,500 junior & senior year. (This blog has a smart tip about using the federal student loan each year.)
Why federal first? These loans do not require a co-signer, offer reasonable interest rates, flexible repayment options, build the student’s credit and don’t jeopardize the parent’s savings and retirement. But they are not always enough.
Still have a funding gap?
After student federal loans are maxed out, do you still have a funding gap? What options remain? Private loans, Parent PLUS loans from the government, home equity loans, or loans on retirement plans are all places you can look to cover this gap.
Before we cover these options, we want to stress the importance of using any of these to fund a SMALL gap. Any of these loans in large amounts can have a profound effect on your client financially. So, keep these loans to a minimum to fund small college funding gaps only.
Parents have two primary loan options to explore first: Parent PLUS and private parent student loans.
Interest Rates & Loan Fees
One key difference between the two is interest rate. Finding the best rate for you will depend on your credit rating. The Parent PLUS loan is a fixed interest rate of 7% for the life of the loan (as of 7/1/17 to 7/1/18). Your credit rating is not considered when setting the rate. (Although you must not have an adverse credit history to qualify.) This relatively high rate is based on a group credit rating.
If you have a better credit rating, your interest rate through a private lender may be lower than 7%. Rates could be as low as 3%.
Is it a fixed rate?
Watch out for introductory rates and initially low variable rates. Variable rates tend to increase over time causing your payments to go up. Private loan interest rates may be fixed or variable. The PLUS rate is fixed and while higher will not change throughout the life of the loan.
Are there origination fees?
For PLUS loans, a loan fee of 4.264% will be deducted from the loan disbursement amount (as of 10/1/17 to 10/1/18). For private loans, any applicable fee depends on the lender so read the terms carefully.
Another key difference between PLUS and private loans is repayment options. Private loans will typically offer different terms like 10, 15, or 20 years. PLUS loan repayment plans include the standard 10 years as well as Graduated and Extended plan options. The Graduated plan payments are lower at first and then gradually increase of the life of the loan (usually 10 years). The Extended plan allows for either fixed or graduated payments but increases the term up to 25 years.
Unless you request deferment of student loan payments, you will start being billed soon after disbursement of the funds (often in 60 days). With PLUS loans, you can elect to defer payment until after the student graduates from college. Interest continues to accrue during that time.
With private loans, they may have more available options. You could start making payments in 60 days, or you could choose to make interest only payments while the student is in college, paying a fixed amount like $25 per month until they graduate, or deferring payments all together until after graduation. Unpaid interest will accrue.
We always recommend parents do not take out private loans in their own names. We would suggest that having the student take out the loan in their name is a better idea. It builds credit and puts the responsibility on the student.
However, students will not qualify for credit on their own so parents will need to be co-signers. Parents need to realize that co-signing the loan makes them just as liable for the payments as their student. Those loans will appear on the parent’s credit report as well. Understand those responsibilities before signing on the dotted line.
Parent PLUS loans are 100% in the parent’s name (the federal PLUS loan program is also for graduate or professional students). Sometimes parents think they’ll be able to transfer this loan to the student after the student graduates. That is incorrect. The parent is the borrower for the life of the loan.
What happens if a parent or student dies? With a PLUS loan if the parent or student dies, the loan is discharged or forgiven. With a private loan, that is not necessarily the case. It depends on the lender.
How do I apply?
To obtain PLUS loans, parents complete the FAFSA each year, and the school will direct you on how to setup the PLUS loan.
To obtain private loans, a good place to start is with your college’s financial aid office. They may have preferred lenders they recommend. However, you are not bound to choose one of those. You can visit websites like www.studentloanhero.com or www.simpletuition.com to find and compare lender information.
Another place to check is with your local credit union. They often offer favorable rates to members.
What About Home Equity and Loans on Retirement?
We went into detail about using your home equity or retirement savings to pay for college in a recent blog.
Sometimes home equity interest rates will be lower than private student loans. Home equity interest and student loan interest are both tax deductible. However, student loan interest is capped at $2,500 (vs. home equity interest at $100,000), and your modified adjusted gross income cannot be more than $80,000 (or $160,000 for married couples filing jointly).
Borrowing from your retirement plan has very little upside. Money taken out of your plan is not earning for you because it is not in the market. Money from your 401k typically must be paid back within 5 years—not a very long term compared to other loan options.
In general, families can find alternate sources of money to pay for college but not for retirement so try to protect the retirement money. It may sound like a good idea at the time but retirement is just around the corner!
There is no limit to how much a parent can borrow so long as it does not exceed the cost…a dangerous situation indeed when college can cost up to $70,000 per year. Carefully consider the long-term impact of taking on too much debt. Families need to choose a college they can afford, plan out how they’ll cover all four years of the costs down to the penny, and use loans wisely to cover small gaps.