I have a simple question: Is there currently a better option to help finance my sophomore daughter's college education than a PLUS loan? — Alan S.
When considering how to finance a college education, there are many options, including federal education loans, private student loans and non-education loans. It is important to carefully weigh the costs, benefits and risks of each option. These include the interest rates and fees on each loan, whether the interest rate is fixed or variable, when repayment begins, repayment plans, options for dealing with financial difficulty and the consequences of default.
Federal Education Loans
The Federal Parent PLUS loan is borrowed by parents of dependent undergraduate students. The annual limit is up to the full cost of attendance minus other aid received, with no aggregate limit. Payments on the Federal Parent PLUS loan can be deferred while the student is enrolled on at least a half-time basis and for six months after graduation.
Eligibility for the Federal Parent PLUS loan
does not depend on financial need, so even wealthy parents may borrow from the Federal Parent PLUS loan program. There is a modest credit check that looks for adverse events in the borrower's credit history, such as delinquencies, defaults, bankruptcy discharge, foreclosure and repossession. The credit check does not, however, consider credit scores or debt-to-income ratios.
The Federal Stafford loan is borrowed by students, not parents. It is a less expensive option, but it has lower loan limits. The Federal Stafford loan comes in two versions, subsidized and unsubsidized. Eligibility for the subsidized loan depends on financial need, while the unsubsidized loan does not. Neither version involves a credit check, so even a borrower with a bad credit history can qualify. The federal government pays the interest on subsidized loans during deferments, such as during the in-school deferment and the economic hardship deferment.
Repayment options for Federal Stafford and PLUS loans include standard repayment (10-year term), extended repayment (10 to 30 year terms based on the loan balance) and graduated repayment (payments increase every two years). Income-based repayment is available for federal student loans but not federal parent loans.
Income-contingent repayment, a predecessor of income-based repayment, is available for Federal Parent PLUS loans that have been consolidated into the Direct Loan program, if the parent did not enter repayment prior to July 1, 2006. Income-based repayment is a safety net that bases the monthly payment on a percentage of the borrower's discretionary income, not the amount owed. Federal student loans offer forgiveness for borrowers who work full-time in a public service field while repaying their loans under income-based repayment in the Direct Loan program.
Both the Federal Stafford and PLUS loans offer a variety of options for borrowers who encounter financial difficulty. Payments may be suspended using the economic hardship deferment for up to 3 years and forbearances for up to 5 years.
Interest, however, will continue to accrue on unsubsidized loans during a deferment and on both subsidized and unsubsidized loans during a forbearance. Accrued but unpaid interest will be capitalized, which adds it to the loan balance. These loans may also be canceled if the borrower dies or becomes totally and permanently disabled.
The optimal strategy from a cost perspective is to have the student borrow from the Federal Stafford loan first. Only if the student has exhausted the Federal Stafford loan limits should the parent consider borrowing from the Federal Parent PLUS loan.
There's also the Federal Perkins loan, which is currently a subsidized loan with a 5% fixed interest rate. Funding for this loan program is limited, with loans awarded by the college financial aid office. President Obama has proposed expanding the program from $1 billion in loans a year to $8.5 billion, but the expanded loan program would offer unsubsidized loans with a fixed 6.8% interest rate.
Private Student Loans
Private student loans include non-federal loans from commercial lenders and from non-profit state loan programs. Most interest rates on private student loans are variable, although some lenders have started offering fixed rates with short repayment terms. More than 90% of new private student loans require a creditworthy cosigner. A cosigner is a co-borrower, equally obligated to repay the debt.
Interest rates are usually based on the borrower's credit scores and the credit scores of the cosigner. Very few borrowers get the lender's lowest interest rate; the majority get the highest interest rate. Repayment terms are less flexible than the federal education loans.
There are also a variety of non-education loans, such as home equity lines of credit (HELOC), home equity loans
and credit cards. Repayment on these loans begins immediately. These loans usually do not offer deferments, forbearances, loan forgiveness or flexible repayment plans. The monthly payment on a credit card is usually a percentage of the outstanding balance, yielding a higher initial minimum monthly payment that decreases over time.
Loan Interest Deductions
Up to $2,500 in interest paid on federal and private student loans is deductible on the borrower's federal income tax return as an above-the-line exclusion from income. The taxpayer does not need to itemize to take advantage of this student loan interest deduction
Interest paid on up to $100,000 in principal on a home equity loan or HELOC is also deductible, but only if the taxpayer itemizes. This deduction may be limited if the taxpayer is subject to the Alternative Minimum Tax (AMT).
Lower Variable Rates May Cost More Than Fixed Rates
In some cases a private student loan or non-education loan will offer a variable rate that is initially lower than the fixed rate on a federal education loan. But these variable rates have nowhere to go but up.
The variable rates may remain low for the next few years, but will start increasing as soon as the Federal Reserve stops suppressing interest rate changes. The interest rates will then start increasing by about 1.5% per year until they return to the neighborhood of interest rates from before the credit crisis.
To calculate the equivalent fixed rate for a variable rate loan with a 10-year term, add about 4 percentage points to the interest rate. So unless the borrower plans on paying off the loan in full in a few years, a variable-rate loan may ultimately cost more than the fixed-rate federal education loans, despite the nominally lower interest rates.
Signs of Over-Borrowing
Needing to borrow beyond the Federal Stafford loan limits is often a sign of over-borrowing, regardless of whether it involves a Federal Parent PLUS loan, private student loan or non-education loan.
Total student loan debt at graduation should be less than the expected annual starting salary. If total student loan debt is less than the annual income, the borrower will be able to repay the debt in ten years or less. Otherwise the borrower will struggle to repay the loans and may need an alternate repayment plan, like extended repayment or income-based repayment, to afford the monthly loan payments.
Parents should also be careful about the amount of debt they incur. Parents should borrow no more for all their children than they can afford to repay in 10 years or by the time they retire, whichever comes first.
Risks of Education Financing
There are also a variety of serious risks associated with borrowing for a college education. Federal and private education loans are almost impossible to discharge in bankruptcy. The federal government has very strong powers to compel repayment of defaulted federal education loans, including garnishment of up to 15% of the borrower's income and Social Security benefit payments and the offset of federal and state income tax refunds (and state lottery winnings).
The federal government can block renewal of a professional license. Borrowers who default on federal education loans are ineligible for FHA and VA mortgages and may not enlist in the military. Private student loans may also garnish wages and seize assets, but only after suing the borrower and obtaining a court judgment.
If a borrower defaults on a student loan, the lender may turn the loan over to a collection agency, which is paid a commission based on the amounts recovered. Collection costs are paid by the borrower, not the lender, so the lender has little or no incentive to limit collection charges.
Collection charges of up to 25% of the principal and interest payment (20% of the total payment) may be deducted from voluntary and involuntary payments on a defaulted Federal Stafford or PLUS loan. Collection charges on the Federal Perkins loan may be up to 30% of the payment for principal, interest and late charges for a first collection attempt and up to 40% for subsequent collection attempts.
If a defaulted federal education loan is rehabilitated, collection charges of up to 18.5% may be added to the loan balance. Private student loans may charge higher collection fees on defaulted loans.
Defaulting on a student loan will ruin the borrower's credit (and the credit history of the cosigner, if any), making it difficult for the borrower to get new credit cards, auto loans and mortgages. The borrower may even find it difficult to rent an apartment or get a job, since many landlords and employers check for bad credit.
If a borrower defaults on a home equity loan or line of credit, the borrower may lose the home. See also Ask Kantro: What are the Downsides to Using Home Equity to Refinance Student Loan Debt