Choosing an Education Loan
The cost of an education loan is usually the most important criterion.
May 14, 2015
Most families evaluate education loans based mainly on cash flow considerations:
• How much money can you get to pay for college costs and/or living expenses?
• How much are the monthly payments?
• When do the payments start and when do they end?
• What is the total cost of the loan (total payments over the life of the loan)?
• Who is responsible for paying back the loan?
This article summarizes some of the key characteristics of student loans according to their impact on these considerations. While the quality of customer service may be worth considering, the cost of the loan is usually the most important criterion.
See also Fastweb’s Quick Reference Guide on Choosing a Student or Parent Loan.
Eligible Expenses and Loan Limits
Most education loans permit the borrower to use the loan funds to pay for any expenses in the official cost of attendance. The cost of attendance, sometimes called the student budget, includes tuition and fees, required books and supplies, room and board (for students enrolled at least half time) and transportation and personal expenses. Some private student loans may limit the loan to institutional charges (i.e., just tuition and fees) especially if the borrower has marginal credit.
The loan may also have annual and aggregate loan limits. The annual loan limit is the maximum amount you can borrow per year. The aggregate loan limit is the maximum amount you can borrow in total. In some cases the aggregate limit applies to just the individual loan program while in other cases the aggregate limit applies to all education debt.
For example, the Federal PLUS loan has an annual limit of the cost of attendance minus other aid received and no aggregate limit. The unsubsidized Federal Stafford loan for undergraduate students has annual limits that range from $5,500 to $7,500 for dependent students and $9,500 to $12,500 for independent students, and aggregate limits of $31,000 (dependent students) and $57,500 (independent students).
Most private and all federal education loans are school-certified, meaning that the college verifies that the student is enrolled and determines the maximum amount the student is eligible to borrow. Private student loan programs may reduce this amount based on credit criteria.
Start of Repayment
Education loans typically specify three time periods: the in-school period, the grace period and the repayment period. Most loans do not require the borrower to begin making payments while they are still in school. Some loans provide for a 6 or 9 month grace period after graduation during which the borrower is not required to begin making payments. During the repayment period, however, the borrower must make monthly payments of principal and interest or they will be considered delinquent (failure to make a payment on time) or in default (failure to make a payment for 120 days on a private student loan or 270 days on a federal education loan).
Certain federal student loans are subsidized, which means that the federal government pays the interest during the in-school period and grace period. These include the Perkins loan, which has a 9 month grace period, and the subsidized Stafford loan, which has a 6 month grace period. These loans are need-based.
All other loans — including the unsubsidized Stafford loan, the PLUS loan and private student loans — are unsubsidized. This means that the interest continues to accrue and is the responsibility of the borrower. If the borrower so chooses, the interest can be deferred by capitalizing it. This adds the interest to the loan balance, increasing the size of the loan. It is a form of negative amortization, in which the loan keeps on getting bigger and bigger.
In all cases borrowers have the ability to begin making payments sooner if they wish, since education loans do not have prepayment penalties. Borrowers can choose to make payments of the interest as it accrues or payments of principal and interest, or they can defer payments of principal and interest until they enter repayment. It is a good idea to pay at least the interest during the in-school and grace periods to prevent the loan from growing. Some private student loan lenders will give the borrower a small discount on the interest rate or fees if the borrower commits to paying the interest during the in-school and grace periods. Other private student loan programs require borrowers to make interest-only payments during the in-school and grace periods. This keeps the borrower informed about the amounts borrowed and the cost of the loan, discourages overborrowing, and helps the borrower establish good credit while they are still in school.
The loan term is the number of years the loan will be in repayment. This affects the size of the monthly payment. A longer loan term reduces the size of the monthly payment, but at a cost of increasing the total interest paid over the life of the loan. For example, increasing the loan term on a Federal Stafford loan from 10 years to 20 years cuts the monthly payment by about a third (34%), but more than doubles the total interest paid over the life of the loan (a factor of 2.18 increase in the total interest). It is best to stick with the shortest loan term you can.
Federal education loans offer several different repayment programs:
• Standard repayment uses level payments for a ten year term. The monthly payments are the same and exceed the interest that accrues. The payments are first applied to interest and then to reducing the principal balance of the loan.
• Extended repayment is like standard repayment, but the loan term ranges from 10 years to 30 years depending on the balance of the loan. This requires you to consolidate your loans, which is like a refinance that merges your loans into a single loan. Examples of the extended repayment terms include 15 years ($10,000), 20 years ($20,000), 25 years ($40,000) and 30 years ($60,000). There is a version of extended repayment that does not require consolidation and which provides a 25 year term if your total loan balance with a single lender is at least $30,000.
• Graduated repayment starts off with low monthly payments and steps up the payments every two years. • Income-based repayment caps the monthly payment based on a percentage of your discretionary income (15% of the amount by which income exceeds 150% of the poverty line). It is best for borrowers who have high student debt and low income. It is better than its predecessors, income-contingent repayment and income-sensitive repayment.
• Most private student loans offer repayment terms of 15 to 30 years, with 20 years being the most common. They use a longer repayment term to reduce the monthly payments below the monthly payments on a 10-year federal student loan despite the higher interest rates and fees on the private student loan. This makes the loans seem more affordable even though the total cost is much higher.
• For example, let’s compare $20,000 federal and private student loans. The federal Stafford loan has a 10 year term and a 6.8% interest rate, yielding monthly payments of $230. The private student loan has a 20 year term and a 10% interest rate, yielding monthly payments of $193. That makes the private student loan seem cheaper, until you realize that the total payments on the private student loan are $46,323 (of which $26,323 is interest), much higher than the total payments of $27,619 on the federal Stafford loan (of which $7,619 is interest). So always ask not just about the monthly payments, but also about the total cost of the loan.
Cost of the Loan
• Besides the loan term, the interest rates, origination fees and default fees have the biggest impact on the cost of the loan. The interest rate is a fee charged annually (or monthly) based on a percentage of the outstanding balance owed on the loan. The origination and default fees are one-time fees charged up-front based on the initial balance of the loan. These fees are always deducted from the disbursement check and are never collected in advance. (If someone asks you to pay the loan fees in advance, it can be a warning sign of an advance fee loan scam.)
• Fastweb provides a loan payment calculator you can use to calculate the monthly payments on a loan.
• Some lenders offer discounts on the interest rates and fees. These discounts are often small and may have stringent requirements for continued receipt. The most common discount is a 0.25% interest rate reduction for having the monthly payments automatically debited from your bank account.
• All else being equal, you should focus on the lowest cost loan. This is usually the loan with the lowest no-fee equivalent interest rate. It may be affected by the deductability of interest on the loan. Up to $2,500 in interest paid on qualified education loans may be deducted as an above-the-line exclusion from income of federal income tax returns. This means you can take the deduction, which reduces your adjusted gross income, even if you don’t itemize on Schedule A.
Who is Responsible for Repaying the Loan
Usually either the student or the parent is responsible for repaying the loan. The Stafford loan is a student loan, while the Parent PLUS loan is a parent loan.
Private student loans are usually student loans, but since students may not have good enough credit to qualify for the loan, a cosigner may be required. A cosigner is a coborrower and is equally responsible for repaying the loan. If the student borrower is delinquent or defaults on a cosigned loan, the lender may seek repayment from the cosigner. The repayment history (including any late payments) on a cosigned loan is reported on the credit history of both the borrower and cosigner and will affect both their credit scores.
Putting it All Together
The following is a list of the most common loans used to pay for college in order from best to worst:
• Perkins Loan
• Subsidized Stafford Loan
• Unsubsidized Stafford Loan
• PLUS Loan
• Home Equity Loan
• Private Student Loans
• Credit Cards