Will you need to borrow to pay for college?
If so, the best strategy will often be to have your child borrow first through the federal Direct Loans. These loans are the responsibility of students, but parents can repay this loan for their children. Most students will be able to borrow up to $31,000 with federal Direct Student Loans.
Unlike other college loans, Direct Loans come with a safety net since they offer valuable repayment plans for students who graduate with no job or who are underemployed. You can learn more about these loans in the lesson entitled, Best College Loans for Students.
When families need to borrow more for college, here are their main options:
- Federal PLUS Loan.
- Private college loan.
- Home equity line of credit.
- Assets in retirement account.
- Help from family.
The PLUS Loan is designed to allow parents to borrow to pay the costs that aren’t covered by a child’s financial aid package. Consequently, the maximum amount that a parent can borrow will depend on how much aid a student received in grants and federal student loans, as well as the school’s cost of attendance.
Here’s an example of how the PLUS works:
A freshman receives a $10,000 merit award from his/her college, as well as a federal Direct Loan of $5,500. The school’s cost of attendance, which would include tuition/fees, room/board, books and transportation, is $50,000.
$50,000 (cost of attendance) – $15,500 (grants/student loan) = $34,500 (amount can borrow via PLUS)
The PLUS Loan originally was originally launched in 1980 to primarily help middle and upper-middle-class families send their children to expensive private colleges, according to a New America Foundation study entitled, The Parent Trap: Parent PLUS Loans and Intergenerational Borrowing. The initial maximum loan was just $3,000 per year, which adjusted for inflation would equal $8,500 today.
Qualifying for a PLUS Loan
Parents can borrow far more than the earlier limits and that is one reason why parents need to be careful when turning to the PLUS Loan. The other reason why the PLUS can be dangerous for some borrowers is because no one is checking to see if parents have the financial ability to repay what can be staggeringly large amounts of debt.
Some parents have gotten into financial trouble because they borrowed far more than they could handle simply because the federal government was willing to lend them the money.
A parent can qualify for a PLUS without a good credit score or the kind of salary that would support future payments. A borrower, however, can’t have certain adverse black marks on his/her credit history. For instance, parents can’t be more than 90 days late on paying a debt and their credit history can’t be marred by a bankruptcy, foreclosure or wage garnishment in the last five years.
If you don’t qualify for a PLUS Loan, your child can borrow more through the federal student loans. (See the chart in the previous lesson entitled, Best College Loans for Students).
If parents can’t qualify for the PLUS on their own, they can still borrow through the PLUS Loan if they can find a cosigner who does not have an adverse credit history.
PLUS loan obligations can rarely be dismissed in bankruptcy court. Lenders can pursue delinquent PLUS borrowers by garnishing wages, income tax refunds and even Social Security checks. In some cases, a parent with a professional license may not be able to get it renewed if his or her credit rating has been destroyed due to bad debt.
The PLUS does offer one welcome protection. If the parent who took out the PLUS dies, the PLUS Loan will be forgiven. (Only one parent takes out the loan.) Because of this provision, it could be advantageous for a parent in poor health to turn to the PLUS Loan.
The government will also discharge the PLUS debt if the parent borrower becomes “totally and permanently disabled.”
Everyone gets the same terms
Everyone borrowing through a PLUS Loan receives the same rate for the year. The interest rate is tied to the ten-year U.S. Treasury so the rate will be different each year. For the 2018-2019 school year, the interest rate is 7% with a 4.27% fee tied to the amount of the loan.
Parents have the option to begin making PLUS Loan payments right away or to wait until their child graduates or otherwise leaves school. To cut down on the total cost of the loan, parents should, if at all possible, begin making payments immediately.
The federal parent loan isn’t nearly as popular as the federal Direct Loan for students and it’s no surprise considering the high interest rate and fees. The federal government makes many billions of dollars off federal parent and student loans.
There is no safety net.
Students who borrow through the federal Direct Loans can enroll in federal repayment programs if their debt exceeds their ability to pay based on their income and household size. The best federal repayment program is called Pay As You Earn. Parents who rely on PLUS Loans don’t have a federal safety net. Students, however, who take out PLUS Loans for graduate and professional-degrees, can take advantage of PAYE and other federal repayment programs.
Check PLUS debt at individual schools.
Expensive for-profit and non-profit private schools tend to have more parents borrowing to cover college costs. The Chronicle of Higher Education created a search engine that shares what the average PLUS Loan amount is for individual schools. You can also sort in a variety of ways including by the average amount borrowed. That’s the factor I used to generate the list below of the schools where the average debt per family is the highest.
Calculate future payments.
Since the federal government isn’t significantly limiting parent borrowing, it’s up to parents to avoid over borrowing. One way to calculate how much is safe is to use the federal loan repayment estimator. I used the calculator to estimate the potential costs using different repayment methods. In my hypothetical example, I calculated what $50,000 worth of PLUS Loans with a 7.21% interest rate would cost to a family. You’ll see the results below.
The cheapest repayment method would be the standard 10-year plan, which would result in payments that would be slightly less than $600 a month. The borrower would ultimately pay $70,908. The most expensive option would be a repayment stretched over 25 years with the initial payments being smaller. Using this method, the tab would balloon to $118,571.
Home Equity Loan
For many parents who have equity in their homes, the home equity line of credit will be the best option.
For parents with excellent credit, the interest rate on a line of credit will be lower than any other available loan for college.
For many parents, their home equity line is going to offer a better starting interest rate (HELOCs offer variable interest rates) and if you itemize on your taxes, the interest is deductible. In addition, bankruptcy remains an option if parents encounter extreme financial difficulty.
As with private college loans, the better the credit history, the better the interest rate offer.
If you borrow through a home equity line, you will reduce the equity in your home, which, in turn, could lessen the financial aid hit when applying to PROFILE schools. Beyond using the line to help with college costs, some families may want to consider using a HELOC to pay off the outstanding balance of other debt such as credit card balances, car loan and personal loan. This certainly should be done in consultation with your tax advisor. After all, this loan would have to be secured with your home.
There is a significant difference between borrowing through a home equity line of credit and a second mortgage. With a line of credit you can take out only what you need, such as when it’s time to pay a college tuition bill. With a second mortgage, you get the entire amount of loan upfront and will have to pay interest on this money from the start. Any unspent money sitting in a bank account, will be considered parental assets. Even worse is if you take out the money and your child will be going to a FAFSA school. By getting a second mortgage, you are taking money from an asset that the FAFSA ignores (primary home) and converted it into an asset that the FAFSA will count against them.
Private College Loans
Another option that families may want to explore is private college loans. These can be an attractive alternative for parents who enjoy very good-to-excellent credit histories. If you fit into that category, the rate you obtain through a private loan could definitely be lower than a PLUS Loan. Private loans offer fixed and variable rates while federal loans have fixed rates.
While parents and student receive the same rates when borrowing through their respective federal college loans, that’s not the case for families using private college loans. Private lenders will charge higher interest rates to borrowers with lower FICO scores and will even base interest rate decisions on what schools students are attending. Families with excellent credit histories will obtain the most favorable interest rates. In contrast, parents with credit scores of 640 or lower may not qualify for any private loans.
Students have traditionally obtained these private loans, but parents (or some other adults) must usually co-sign. According to a federal report about 90% of private college loans have a cosigner. If the graduates can’t repay their loans, the lenders will go after the cosigners.
Don’t just look at the big names.
Private student loans used to be dominated by the nation’s major banks, but the recession that began in the late 2000’s ended up chasing away most of the big players including Citibank, Bank of America and Chase. The biggest player remains Sallie Mae, which has had a troubled history in this niche. Other alpha dogs are Wells Fargo and Discover.
When big banks fled this market, credit unions, which see student loans as a natural extension of their mission, filled the void. Non-profit credit unions are also interested in seeking younger customers and they view college loans as a way to reach out to them.
Also entering the market have been online lenders such as College Avenue Student Loans, CommonBond, DRB Darian Rowayton Bank and SoFi. The latter two offer only college loan refinancing.
Loan shoppers typically gravitate to the major lenders with the recognizable names and big marketing budgets, but the big boys usually do not offer the best deals. Your best bet will likely be at credit unions or online lenders.
To be eligible for a credit union loan, borrowers will have to join the financial institution. There are few national credit unions which means that families will usually have to look for credit unions in the area where they live or where the student will be attending college. A regional credit union, for instance, may only serve families in 20 zip codes.
New loans for parents.
A new type of private college loan is now available exclusively for parents. These loans allow parents to take on college debt without involving their children. For parents with very good to excellent credit scores, these private loans can offer lower interest rates and fees than the federal PLUS Loan for parents.
There are currently a handful of private lenders who originate private college loans for parents:
- Citizens Bank
- Citizens One
- Sallie Mae
- Wells Fargo
An excellent place to learn more about these new private college loans, as well as traditional private loans, is Private Student Loans Guru. Mark Kantrowitz, a nationally recognized financial aid expert, who is publisher at Cappex, a popular college search resource, recently created this free website.
On Private Student Loans Guru, you’ll find a tremendous amount of information about the advantages and disadvantages of private college loans, as well as how they compare to federal loans. The site also shares links to the private lenders.
Use Loan Search Sites
Here are some online resources to find private college loan lenders:
This site allows you to compare private education loans by first analyzing your submitted information and your credit report with lending criteria to determine whether you qualify for a loan offered through a participating lender. Marketplace enables you to see the actual rates and terms for which you qualify, based on the information you provided. By determining the actual terms, rather than simply providing a range of rates and generic terms, the site can help you do a better job of comparing choices.
Credit Union Student Choice, which was founded by leading credit unions in 2008, has helped hundreds of fellow credit unions offer private college loans for undergrads and graduates students, as well as private consolidation loans. Below you’ll see the screen shot of the search engine that you can use on the website to locate participating credit unions and eligible schools. Each credit union will set its own loan rates.
Lendkey offers private college loans to students, as well as private college loan consolidations through a series of credit unions. The rates these credit unions quote will be the same and are based on the three-month LIBOR, a popular financial benchmark that is based on the interest rate that banks offer to lend money to each other.
This website provides loans offered through a network of community banks. Because of the nonprofit structure of credit unions, it can be hard for banks to offer the most competitive rates.
Check college credit unions.
If a college has a credit union, you might be able to get a private loan this way. Here are some institutions that have a credit union:
- Harvard University
- University of Chicago
- Amherst College
- Hampshire College
- Mount Holyoke College
- Smith College
- University of Massachusetts
- University of Wyoming
- University of Kentucky
- Princeton University
- California State University system
- Eastern Iowa Community Colleges
- University of Wisconsin
Don’t assume you’ll get the lowest rate.
The teaser rate on private loans can look much more attractive than federal college loans. One long-time veteran in the college loan industry, who has seen tens of thousands of loans, told me that only about five percent of borrowers capture the teaser rate. To qualify for this rate, your credit scores should be nearly perfect. The difference between the lowest rate and the highest rate at an individual lender can be huge.
Ask the right questions.
Before committing to a private loan, here are some questions to ask:
- What is the interest rate?
- What is the APR?
- Is the rate fixed or variable?
- Is there an interest-rate cap on a variable loan?
- What is the total cost of the loan?
- What are the requirements for a co-signer release?
- What percentage of cosigners has ever been released from your loans?
- What are the student loan deferment options both during and after school and are there any hardship waivers?
- Are there any additional fees?
- How difficult is it to consolidate loans and cut interest rates after graduation?
- Does the loan offer penalty-free pre-payments?
- How long is the grace period?
- What are the borrowing limits?
- Is there a discount for on-time payments?
- What happens to the loan if the borrower dies or becomes disabled?
Using Retirement Accounts to Help Pay for College
Raiding your retirement account to pay for college will almost always be the worst option. If you pull money from your retirement accounts, you obviously will have less to live on when you do leave the working world.
Here’s are the tax ramifications of tapping retirement accounts for college:
In addition to paying income tax on withdrawals, a parent would have to pay a 10% early withdrawal fee if he or she is less than 59 1/2 years of age. If the account owner has left the company, he/she could withdraw money without incurring the penalty at age 55.
The penalty and the federal income tax (highest tax rate is 39.6%) could chew up a significant portion of the withdrawal.
Borrowing For College With a 401(k)
Some parents use their 401(k) account to borrow for college. This practice won’t trigger taxes or a penalty, but it is risky for two main reasons.
No. 1: Some parents consider borrowing through their 401(k) for a variety of expenses a great option because they are repaying the money back into their own accounts. While a parent is repaying his/her 401(k), they often aren’t contributing new money into their nest eggs.
No. 2: Parents will have to repay their 401(k) loans for educational purposes in five years. If the parent leaves the company, the full amount of the loan will come due. If the parent can’t repay the loan, it will be treated as a withdrawal that is subject to taxes and an early withdrawal penalty.
Individual Retirement Accounts
Just like 401(k) withdrawals, tapping money in an Individual Retirement Account will also be subject to taxes. You can, however, withdraw money from an IRA to pay for qualified college expenses prior to age 59 1/2 without triggering an early withdrawal penalty.
Unintended Consequence of Tapping Retirement Accounts
When a parent withdraws money from a retirement account, whether it is for college or not, that sum of money must be reported as parent income on the FAFSA during the following year. This could end up reducing a child’s chances for need-based financial aid.