College is expensive. Yes, really expensive. Even families who don’t qualify for financial aid can often struggle to pull together the funds to pay a $10,000, $20,000 or $30,000 bill in one fell swoop.
Borrowing college loans has, therefore, become much more common, with nearly three-quarters of college students graduating with some type of debt, according to The Federal Reserve. And that’s just students. The amount of debt taken on by parents to finance their children’s college education is much harder to pinpoint, due to the variety of types of financing available to parents, but the numbers are certainly substantial. If you’re considering borrowing loans to help pay for college, it’s important to understand your financing options.
Federal Direct Loans
Federal Direct Subsidized and Unsubsidized Loans are the most popular loans in the student loan market, and, actually, are usually the only loans that students can borrow in their name alone.
In order to receive a Direct Loan, you must simply complete the FAFSA and meet very basic eligibility requirements. There is no co-signer and no credit check required, and the interest rate is relatively low (5.045 percent for the 2018/19 school year). These government loans offer substantial borrower protections, such as in-school deferment, flexible repayment plans, death/disability cancellation and the possibility of Public Service Loan Forgiveness.
Students deemed to have “financial need” qualify for the Subsidized Loan, which does not accrue interest while the student is enrolled in school, while all eligible students can borrow an Unsubsidized Loan, which begins accruing interest immediately. Between both versions of the loan, however, a student can borrow no more than $5,500 to $7,500 per year, depending upon the student’s year in school.
If a family needs to borrow more than this modest amount, many turn to the Direct PLUS Loan program, another government loan program offering protections similar to those offered on the Subsidized and Unsubsidized Loans. The PLUS Loan, however, is in the parent’s name, rather than the student’s, and is not quite as automatic as the student loans. Parents do need to pass a credit check to qualify for the PLUS Loan, and the interest rate is not as favorable (7.595 percent for 2018/19, with a somewhat hefty origination fee of just over 4 percent). Students should certainly tap the more favorable Subsidized and Unsubsidized Loan programs before families consider a PLUS Loan, but once student loan eligibility is exhausted, the PLUS Loan can fund any remaining gap up to the total cost of attendance of the college.
Private Education Loans
Families dubious of the PLUS Loan interest rate and origination fee often choose to try their luck in the private education loan market. Private loans can be borrowed through traditional brick-and-mortar banks, newer online-only lenders, and state financing authorities.
Loan terms will vary by lender, but most private loans are structured as a student-borrowed loan with a parent co-signer. Parents with excellent credit may be able to get a lower interest rate in the private market than they would have received on a PLUS Loan. Families should make sure they understand, however, their repayment options and what borrower protections, if any, are offered on the private education loans they’re considering.
Home Equity Loans
Some families stay out of the education loan market altogether and choose to borrow a home equity loan instead. While the recent tax reform law, which eliminated the tax deductibility of home equity loans used to pay for college, made home equity a less favorable borrowing option than in the past, many families will still find tapping their home equity to be the most effective means to accessing the lowest possible interest rate. Parents need to be comfortable, however, with the risk involved in putting their house up as collateral to pay for college.
Finally, some parents choose to borrow from their 401(k) to pay the tuition bill. The prospect of paying yourself, rather than a bank, back certainly has its appeal and may work well for families finding themselves just a bit short on college costs.
Families should note some drawbacks of 401k loans however. First, you are limiting the growth potential of your 401k during the years the loan is outstanding, and, when you pay yourself back, the interest you pay yourself consists of after-tax dollars. When you eventually withdraw this money in retirement, the withdrawal is taxed again – a rare occasion in the U.S. tax code when the same money is actually taxed twice.
In addition, most 401k loans are limited to $50,000 and must be paid back within five years (unless you separate from your employer, in which case, the loan must be paid back immediately). If you’re able to pay back four years’ worth of college costs in five years, perhaps you can just stretch your budget a bit and pay the four years as they come without having to borrow at all.
Tuition Payment Plans
And speaking of not borrowing at all, one last financing option which I feel is underutilized on many college campuses, is the tuition payment plan.
While the default payment schedule at most colleges is to pay twice per year – once in summer for the fall semester and once in winter for the spring semester – this billing calendar can be challenging for those families who have not saved extensively for college.
If you don’t have a substantial nest egg to tap to pay that big fall bill, don’t immediately jump to borrowing a loan to spread out your college costs. Instead, ask the college if they offer a tuition payment plan that will allow you to divide your yearly payment out on a monthly basis. Most tuition payment plans charge a modest sign-up fee to pay monthly, but this fee will likely pale in comparison to the prospect of paying five, 10 or 20 years’ worth of interest on a college loan. Be sure to review your household budget and determine what you can pay out of pocket before even considering borrowing a college loan.