How to Choose the Best Education Loans
Know your student loan options before you borrow.
May 14, 2015
With the new Obama tuition plan do you now have to go through FAFSA to get a loan? Is it better to take a loan out in my child’s name or take a parent PLUS loan? — Michelle A.
All federal education loans are now made through the Direct Loan program. This includes federal student loans, such as the subsidized and unsubsidized Stafford loans, and parent education loans, such as the PLUS loan. To obtain a federal education loan, contact the financial aid office at your child’s college.
The unsubsidized Stafford loan and the PLUS loan do not depend on financial need. The subsidized Stafford loan depends on financial need. Filing the FAFSA is a prerequisite for obtaining a Stafford loan. The FAFSA is not required if you are only interested in a Parent PLUS loan, since a loan application and promissory note will be sufficient. (The FAFSA is, however, required for a Grad PLUS loan.) But it is better to submit the FAFSA anyway, since your child may qualify for the subsidized Stafford loan and maybe even some federal and state grants.
The Stafford loan has a lower interest rate and lower fees than the PLUS loan, so your child should borrow the Stafford loan first. The PLUS loan is available after the Stafford loan limits have been exhausted. Income-based repayment is available as a safety net for the Stafford loan, but not for the Parent PLUS loan (or private student loans).
Is it true you can get loans for college and do not have to pay them back as long as you get your Master’s degree? — Paul D.
This is a myth. It is not true. While education grants do not have to be repaid, student loans have to be repaid with interest.
You do not have to repay your student loans until six months after you graduate or drop below half-time enrollment. If you enroll in graduate or professional school immediately after receiving your Bachelor’s degree, you can continue to defer repayment of your loans while you are still in school. But once you graduate with your Master’s or other advanced degree you will have to begin repaying your loans.
Some employer tuition assistance programs will pay for all or part of an employee’s education, but only if the employee maintains a minimum GPA. In a few cases the employer will reimburse the tuition expenses only if the employee graduates with the degree.
There are also a variety of loan forgiveness programs for working in a particular career, such as public service. For example, the TEACH Grant requires the recipient to work as a teacher in a national need area for four of the eight years after graduation. If the recipient fails to fulfill the service requirement, the grant is retroactively turned into an unsubsidized Stafford loan.
I want to know if it makes more sense to use money available in a home equity line of credit (2.74%) to pay some of my son’s college tuition or a private student loan (8.5%). I know the HELOC is a lower rate, but my concern is about getting into a position of having no equity left in my house if ever an emergency came up. — Marie P.
You should borrow federal first, as federal education loans are cheaper, more available and have better repayment terms than a private student loan or home equity line of credit (HELOC).
Both HELOCs and private student loans are variable rate loans, while federal education loans have fixed rates. Home equity lines of credit are typically repaid over 10-15 years and most private student loans are repaid over 15-30 years. You should consider that interest rates are currently unusually low, so the interest rates on variable rate loans are likely to increase significantly over the next few years. As a result, the variable rate loans will probably cost more over the life of the loan than a fixed rate federal education loan. Unless you are certain that you will be able to pay off the variable rate loans in full within the next few years, the federal education loans will be less expensive in the long term.
If you’ve exhausted your eligibility for federal education loans, however, home equity lines of credit and private student loans can help fill the gap. In most cases a HELOC will have a shorter repayment term than a private student loan. This may yield lower monthly payments on a private student loan than on a HELOC, even with the private student loan’s higher interest rate, but the total interest paid over the life of the private student loan will be much higher.
While saving money should be a primary consideration in choosing a loan, there are several additional factors that should be considered. As you noted, using the HELOC will decrease the equity in your home. You could end up owing more on your first mortgage and the HELOC than your home is worth. If you default on the HELOC, the bank can foreclose on your home, while an education lender cannot repossess your son’s education. Double check to make sure that the 2.74% rate is not a teaser rate that will increase a year after you tap into the line of credit. Also, if your remaining home equity drops too low, you might have to pay private mortgage insurance (PMI). Verify that the loan does not include a prepayment penalty; federal and private student loans do not have prepayment penalties.
Interest paid on both the HELOC and student loans can be deducted on your federal income tax return. The HELOC interest is deducted on schedule A and may be subject to the Alternative Minimum Tax (AMT). You cannot deduct interest on more than $100,000 of home equity debt ($50,000 if married filing separately). The student loan interest can be deducted as an above-the-line exclusion from income even if you don’t itemize, and is not subject to the AMT. However, the student loan interest deduction is capped at $2,500 in interest a year.
Other possibilities include a home equity loan, as opposed to a line of credit, or a cash-out refinance. Home equity loans often have a much higher interest rate, but the interest rate is fixed. However, the money from the home equity loan may hurt your son’s eligibility for need-based financial aid.