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). Eveneducation 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, thevalue 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 nodebt. 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 reportable assets. 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 loans. (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 the student. 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.
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