A great college funding plan considers the different types of student loans and has three steps. The first step sets up your resources and budget. The last blog post focused on this topic. We reviewed how to create a college funding budget and compared it to the pre-approval process of buying a home. Also, the post explored the different funding categories. Loans made up two of those categories – one for parents and one for students. The second step in your college funding plan creates a smart lending strategy so the student or parent does not create a future financial burden. The last step is to shop for college. We will study this topic in later posts.
Today, we focus on the second step by examining the different types of student loans. As mentioned in other works, there are two major categories of student loans: federal loans and private loans. Each category may break down further into student or parent loans. Student loans refer to debt that is in only the student’s name. Parent loans may be in the student’s name but the parent acts as a co-signer, or the loan may be in only the parent’s name.
Stafford loans are the most common type of federal student loan. These loans will be either subsidized or unsubsidized. Among the loans, three differences exist: 1. The government pays the interest on subsidized loans while the student attends college. 2. The eligible amounts for subsidized loans are lower than those for unsubsidized. 3. A student must qualify for the subsidized loan, while every undergrad student is eligible for the unsubsidized loan. The student qualifies for subsidized loans by demonstrating financial need. To put it in a simple math formula (1.):
Cost of Attendance – Expected Family Contribution = Demonstrated Need
As you saw in my other post about expected family contribution, calculating this number is anything but easy. However, from the formula above, you get the basic of idea of how to qualify for subsidized Stafford loans. The government manages the amount it will cover in loan interest by limiting the amount of the subsidized loan. Depending on the amounts, a student may borrow the following under a subsidized loan: $3,500 for freshmen, $4,500 for sophomores, and $5,500 for juniors and seniors.
As mentioned earlier, every student qualifies for unsubsidized loans. The dollar amount a student may borrow depends on the grade level: $5,500 for freshmen, $6,500 for sophomores, and $7,500 for juniors and seniors. With this type of loan, the interest starts accumulating at the loan’s origination.
The two types of loans may be used together but the amount borrowed in any one year should not exceed the higher limit of the unsubsidized loan. If a student qualifies for subsidized loans, this will be used to the maximum first; then an unsubsidized loan will be added to the amount and not exceed the limit. Interest rates are fixed for the life of the loan and reset for new loans every year.
Perkins loans are another type of student loan that may be used. They are low-interest loans for grad and undergrad students who demonstrate exceptional financial need. The school is the lender and payments are made to the school or its service provider. Not all schools participate in the Perkins loan program, and funds may be limited (2.) Students with a high need should check with the school’s financial aid department for participation details. This loan program is not as popular as Stafford loans.
Parents may help students pay for college using a Parent PLUS loan. Parents of PLUS loans may acquire loans for dependent undergraduate loans (3.) These loans are not accessible to other students, namely graduate and independent students. Divorced parents may both acquire loans, but the total between them cannot exceed the loan limits (3.)
The total amount that parents may borrow for any one year follows the formula below:
Full annual cost of attendance – other financial aid the student received = Potential PLUS loan
Parent PLUS loans require no debt-to-income ratios and are not dependent on the borrower’s credit score (3.) As a result, the interest rates on these loans are rather steep. The current interest rate for the 2017-2018 academic year is seven percent with a 4.264% origination fee, making the real first-year rate for the loan 11.264%. As you can see, this high rate can quickly put families in trouble. Now just imagine the problems faced by families that take out these loans year after year.
Repayment of the loans typically starts 60 days after the loans are fully dispersed (3.) However, loans after July 1, 2008, can be deferred while the student attends school at least half-time (3.) The standard repayment applies to a 10-year repayment schedule. Income-based repayment schedules typically cannot be used with Parent PLUS loans, but they are eligible for student loan forgiveness (3.) PLUS loan consolidation cannot be done with other federal loans in the student’s name.
To apply for PLUS loans, parents fill out the FAFSA, then request the loan through StudentLoans.gov. You can also contact the financial aid department of the student’s college or university.
Private student loans vary greatly in terms, payment provisions, and features. For the most part, private loans lack many of the common features of federal loans, like fixed interest rates and income-based repayment plans, and are not subsidized (if you qualify). Most private student loans are issued by banks, credit unions, state agencies, or even the schools themselves.
Many private loans require repayment while the student attends college. Some of these loans require an established credit history or a co-signer (often the parent). Student loans commonly use variable rates. If interest rates rise, the loans become more expensive. Additionally, the loan may not be consolidated into a Direct Consolidation Loan and it may not have forbearance or deferment options.
In general, private loans do not compete with the flexibility or features of most federal loans. However, private loans constitute one of the fastest growing types of loans. See the graph below.
As noted above, the federal government limits the amount a student may borrow in Stafford loans. The price of tuition continues to rise year after year. As a result, programs like Parent PLUS and private student loans experience large growth.
Many graduates to wonder how they will pay back their complicate and confusing student loans. As we saw, student loans divided into federal and private loans and further split into parent and student-only loans. Federal loans give the borrower attractive terms as compared to private loans in general.
Student loans are the focus of the second step in creating a smart college funding plan. The student and family should know how much they can afford if the college budget is established up front, thus reducing the number of surprises upon graduation.
The next post discusses paying back student loans. It starts with a smart lending strategy.