The ABCs of College Loans
Congratulations on your child's college acceptance. Now for some sobering news. Tuition costs are rising by more than 10% at many schools, far outstripping the 2.2% average increase in personal income. Meanwhile, the bear market has taken a bite out of college endowments that fund scholarships -- and you've seen how it has whacked your own savings. As a result, you may have to borrow more than you had expected to plug the gap between personal savings, financial aid, and the cost of a degree. "Colleges and parents are feeling squeezed," says KC Dempster, director of program development at College Money, a Marlton (N.J.) educational planning firm.
Still, if you have to borrow, things could be worse: Interest rates on federally backed college loans -- already at historic lows -- are likely to drop further on July 1, when the government sets rates for the next 12 months. Moreover, with many lenders offering discounts, you can cut the cost of borrowing to as little as 2%. Also compelling for high-income families are home-equity loans that give you a fat tax break.
Before shopping, first figure out which type of loan makes the most sense for you. The answer depends, in part, on your tax bracket, whether you qualify for financial aid, and who will be incurring the debt -- parent or student. In making a selection, you'll have to weigh trade-offs. For example, while the deductibility of home-equity loan interest is attractive, these loans may jeopardize your child's financial aid eligibility. Government-backed loans -- available to anyone, regardless of income -- require no collateral and offer lower rates and more flexible repayment terms than most alternatives. But their rates change every July 1 -- a liability if interest rates rise.
The two most common federal loans are PLUS loans for parents and Stafford loans for students. Interest currently accrues at 3.46% on Stafford loans. But students can defer repayment until six months after graduation, at which point the rate rises -- today's is 4.06%. Borrowing is limited, though, to $2,625 for freshmen, $3,500 for sophomores, and $5,500 each for juniors and seniors. In contrast, with a PLUS loan, parents can borrow the entire cost of college at 4.86% this year. To apply for either, you must complete a Free Application for Federal Student Aid (FAFSA) form. Because you can borrow only for one year at a time, you'll have to take out separate loans in each year.
Your child's choice of school determines where you can go for federal loans. Some schools contract directly with the government, leaving you no choice but to get your loans from Uncle Sam at the published rates. At other schools, you are free to comparison-shop -- so don't accept the financial aid office's list of preferred lenders as the final word.
It's hard to beat some of the deals lenders are offering. When hunting for discounts, start with agencies that oversee financial aid in your home state or the state where your child attends college. Pennsylvania, for example, knocks two percentage points off the rate on PLUS loans -- one point after two years of on-time payments, and another point after two more years. On Stafford loans, it takes 1% off the standard 3% origination fee, then shaves up to 2.25 points off the rate to reward on-time payments and those deducted from a bank account.
Another source of bargains is a network of about three dozen nonprofit lenders. Because most are regional, you'll need to search -- www.efc.org has links -- for the one that covers your turf. Bill Louis, a senior at the University of Missouri at St. Louis, will save 2.5 points on a Stafford loan thanks to the Missouri Higher Education Loan Authority, a Missouri nonprofit. MOHELA makes PLUS loans nationwide, while its Stafford rebates are primarily available borrowing from certain banks in Missouri, Arkansas, and Mississippi.
The rebates come with a few caveats. You get them only if the nonprofit's income exceeds a government-mandated level. Still, MOHELA Executive Director John Wild says he expects to continue the incentives for "several more years." Also, when the rate reductions kick in, your monthly payments don't fall. Instead, you'll retire your debt early, says John Wright, a director at Versura, a Washington, D.C., education consulting firm.
National lenders also offer discounts. Education Loan Resources (elresources.org) reduces the rate on Stafford and PLUS loans by two percentage points if you pay on time and allow bank account deductions. It also rebates half the 3% origination fee. Sallie Mae will cut your rate by 0.25 point for direct payments from a bank account. Those who pay on time for the first 33 months may also qualify for a principal reduction -- 3.3% is standard. Still, if you plan to pay back your loan over 10 years, you'll save more with a loan that reduces your rate by two points than with one that returns 3.3% of principal, says Wright.
If the student shoulders most of the debt, he or she might need a bank loan in addition to a federal student loan. Parents, too, might qualify for better deals. Some private lenders offer discounts to those with stellar credit. And some schools make low interest loans or partner with banks that do it for them. Princeton University, for example, offers 2.1% variable loans and 4.95% fixed loans to parents earning $374,888 or less.
Couples earning less than $130,000 can deduct up to $2,500 in interest payments on education loans. If your income is above that limit, you can still get a tax break through a home-equity loan of $100,000 or less. To figure out the aftertax rate on a loan, subtract your tax rate from one and multiply the result by the loan's interest rate. With home-equity loans at about 7.53% today, the aftertax cost is 4.6% for someone in the 38.6% bracket. That's still more than the 3% you'll pay for a PLUS loan with discounts. But the home-equity loan has a key advantage -- a fixed rate that protects you if rates increase.
You can lock in a fixed rate on your federal loans if you have two or more loans that can be consolidated into one. But since many believe federal loan rates are likely to head down before they rise, you might want to wait before consolidating. Indeed, with college costs escalating, you deserve all the breaks you can get.
By Anne Tergesen