Why is it better for parents to pay off credit cards (if one can)
before obtaining loans for a child for college?
— Diane H.
Most forms of consumer debt, such as credit cards and auto loans, are
ignored on the Free Application for Federal Student Aid (FAFSA). Even
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education loans are ignored. The only exception to this rule occurs
when the debt is secured by an asset that is reported on the
FAFSA. For example, the value of a brokerage account is reduced by any
outstanding liabilities or indebtedness against the account, such as a
margin loan. The market value of a vacation home or investment real
estate is reduced by any mortgages against the property. However, the
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value of the family's primary home is not reduced by any mortgages
secured by the home because the net worth of the family's principal
place of residence is not reported as an asset on the FAFSA.
Thus the FAFSA treats two families with similar income and assets the
same, even if one family has high credit card debt and the other has no
debt. The family with high debt is in a much weaker financial
position, but they are given no credit for this debt. This is a big
flaw in the design of the federal need analysis formula.
Money in the bank, however, does count against student aid
eligibility. So the family can improve eligibility for student
financial aid just by paying off debt, because this will reduce the
Credit card debt is a good example because it is among the most
expensive forms of debt, with the highest interest rates. Using money
from a bank or brokerage account to pay off credit card debt will not
only improve eligibility for federal student aid, but it will also
save you money. For example, suppose you are earning 2% interest on a
bank account but paying 13% interest on a credit card, each with a
$10,000 balance. The bank account earns $200 a year while the credit
card debt costs $1,300 a year. By paying off the credit card debt you
lose the $200 in earnings but you also avoid the $1,300 in interest
payments, yielding net savings of $1,300 - $200 = $1,100 a year. You
also improve your cash flow, since you will no longer be making
monthly payments on the credit card debt. (This assumes, of course,
that you will cut up the credit cards or take other steps to resist
the temptation to run up the credit card balance again.)
Suppose you have enough cash in the bank to pay off your credit card
balance. If you pay off the credit card debt, you might need to borrow
education loans to pay for college instead of spending some of your
savings. In effect, you will be substituting college loans for credit
card debt. Since federal education loans typically have much lower
interest rates, you will be reducing the cost of your debt, saving
money. The federal education loans also provide more flexible
repayment terms than credit cards, such as deferments during the
in-school and grace periods and periods of economic hardship. The
education loans also have a variety of repayment plans, such as
extended repayment, graduated repayment and income-based
repayment. The minimum payment on a credit card is usually a
percentage of the outstanding debt, which initially yields a much
higher monthly payment than the monthly loan payment on most education
(It's a closer call when you compare credit card debt with private
student loans. Generally private student loans are less expensive
because they have lower interest rates than most credit cards. The
main advantage of credit card debt over education loans is that credit
card debt can be discharged in bankruptcy while it is almost
impossible to discharge education loans in bankruptcy.)
Parents may also prefer education loans over credit card debt because
the student loans shift some of the debt burden from the parents to
Fastweb's new Quick Reference Guide on Choosing a Student or Parent Loan
provides additional reasons why federal education loans are better
than credit card debt.