As of February 2020, about half of Americans expect to live paycheck to paycheck this year. Keep in mind that this report came before COVID-19 really impacted the US jobs market. Now, that percentage is likely higher, especially for people in the travel and service industries.
This means that many parents probably do not have much disposable income to save for their children’s education after they have covered their mortgage, other fixed expenses, and save for retirement.
As a result, many families, even those with higher incomes, may need to take out student loans for their student’s college costs.
So, where do you begin exploring your options, and what are the BEST loans to consider first?
In this post, I hope to help both parents and students understand and sign up for the optimal student loans given their current credit scores and overall financial situation.
Federal Loans: The First Step
First, you should evaluate the Federal Direct Loans (both subsidized and unsubsidized) that every family is offered regardless of income or assets. To become eligible for these (formerly called Stafford loans), you must complete the FAFSA (Free Application for Federal Student Aid) in the fall of the student’s senior year of high school, and then every year after that.
You can submit the FAFSA starting on October 1st each year, and the schools look at your incomes from the previous tax year and your assets the day you complete the FAFSA to determine financial aid eligibility. It is always in your best interest to submit the FAFSA on or very soon after October 1st because some scholarships and aid are first-come, first-serve.
At lower incomes, federal loans may be mostly subsidized, which means no interest accrues when the child is in college. Unsubsidized debt means the interest does accrue while the student attends undergrad.
For the 2020-2021 school year, the interest rate on Federal Direct Loans for undergrads has dropped from 4.53% to only 2.75%! Plus, there are no origination fees or other additional costs. So, the amount of accrued interest is very low even with the unsubsidized debt.
The government offers up to $5,500 in Direct Loans for freshman year, $6,500 for sophomore, and $7,500 for both junior and senior year. In total, this is $27,000 of debt over four years, which is roughly the current cost of one full year of education at an in-state, public university (including room and board).
The loans are fully in the student’s name, so parents do not need to co-sign for these low interest rates.
Why Take Out Federal Loans?
I often encourage parents to accept these federal loans for their kids even if they can afford to pay for all of college in order to save more for retirement.
Funding college is hard, but it may only be for four years and there are many ways to pay for it. Retirement could last for 30 years between you and your spouse, and you can’t borrow money or earn scholarships for retirement; it should always be the priority. If you spend too much money out of pocket on college, then your children may end up being financially responsible for you when you’re 90 because you ran out of money.
That said, many families I meet have a goal to put their children through undergrad with no debt and stay on track for retirement simultaneously.
Even if you take 100% of the federal loans, that still means parents are on the hook for the other three years of cost. Assuming your child attends an in-state public school, this would be close to a total of $81,000 per child (average annual cost of attendance of $27,000 x 3 years). Note: private or out-of-state schools could cost more.
Of course, you can elect to take less than the maximum federal loans. For example, the student could take out $3,000/Yr. for four years, amounting to only $12,000 total of undergrad loans if you want to limit their debt.
Federal Loan Repayment Flexibility
After graduation, there is a six-month grace period before payments are due. With the standard 10-year loan repayment of $28,000 ($27,000 principal + ~$1,000 interest accrued) @ 2.75%, the monthly amount due is about $267/Mo. If the student wants to pay the debt back quickly over five years, it is about $500/Mo., like a high-end car payment.
There is no penalty for loan prepayment. In case of death or permanent disability, all federal direct loans are forgiven so that family members are never burdened with the debt.
Any interest up to $2,500/Yr. paid on these loans is tax-deductible assuming MAGI (modified adjusted gross income) of less than $70,000 and is totally phased out at over $85,000/Yr. income for a single person.
In addition, the borrower can elect “income-based repayments” where you only must pay 10% of your income earned above 150% of the poverty line (150% of the poverty line is about $20,000/Yr.). So, let’s say your college grad enters the working world but only earns $25,000/Yr. doing an internship. In that scenario, the monthly payment due would only be 10% of $5,000/Yr. ($500), so $41.67/Mo.
Check out the finaid.org student loan calculator if you want to run different loan scenarios.
A Note on Graduate School
In addition, your student can defer all federal loan payments if he or she goes to graduate school. Unlike undergrad, you can cover 100% of the costs for graduate school with these types of federal loans. In other words, there is no cap on grad school debt from the government.
Check out my other blog here that dives into how graduate school debt works in detail.
This undergrad plus grad school debt can all be consolidated into one monthly payment of just 10% of discretionary income. These loans can be forgiven in 10 years (government and non-profit sector) and 20 years (private sector) with minimum income-based repayments. Check out my article above for more details on those programs.
The other federal student loans offered to all families regardless of income or assets are called Parent PLUS loans. You must have a reasonably good credit history to be eligible for them.
Here, the loans are in the parent’s name, not the student’s name. The interest rates on these loans just dropped from 7.08% for the 2019-2020 school to 5.30% for 2020-2021. Federal direct loan rates are tied to the US 10-year treasury bond, which is at historical lows right now during the crisis.
Unfortunately, there is a 4.24% origination fee on the loan principal, which makes them less attractive than many student loans in the private sector. I see parents often sign up for these Parent PLUS loans without exploring other options because it is very convenient, or they have heard that private loans are too risky. It is worth your time, however, to first compare these Parent PLUS loans with what is available in the private market.
For private student loans, the parents or guardian will likely need to co-sign since most high school seniors do not have a credit history. If you have a good credit score (above 700), you can get fixed rates around 4% with several companies. Variable interest rates are as low as 1.24% right now but will likely go up after the CV-19 crisis subsides.
Here is a good list to reference from NerdWallet to shop out student loan options for July 2020.
Some Helpful Private Loan Tips and Resources
- Make sure you confirm whether there are any loan origination or other hidden fees before accepting any offer.
- If you have a decent credit score but not great (600-650), you may be better off taking the Parent PLUS loans because your interest rate as cosigner could be 7% or more.
- Apply for a few different companies to get the best possible deal.
- Remember that Parent PLUS loans are 100% in the parent’s name, whereas private student loans are typically in the student’s name but co-signed by the parents or guardian.
The College Funding Coach also has a partnership with Sallie Mae where you can get a slightly discounted rate. Sallie Mae is a good starting point to explore alternatives because they offer competitive interest rates and do not charge any loan origination fees.
We also have collaborated with a fascinating company called LeverEdge, which is the first organization to use group negotiation to bring down interest rates on private loans.
I recommend taking a look at our resources page which provides a ton of info on student loans.
Unlike federal loans, private loans typically do not offer income-based repayments and are much less flexible in general. Also, in cases of death or disability, the parent could be on the hook for the loans as cosigner—God forbid the unforeseen happens. You could also be on the hook for the loans if your student is not able to make payments due to low income. Make sure you understand the long-term implications of taking on these loans and how they can potentially impact your retirement.
If you find you need to take almost all loans to fund undergrad, you may want to consider in-state or community colleges that reduce the overall debt for both parents and the student.
In other words, students need to bring the future into the present and realize how much their monthly payments will be after graduation. Parents need to be careful since they are cosigning. What if your student pursues a lower-income career and cannot afford the payments? What if the student graduates during a recession and is living at home for a little while? These private loans do not usually offer the flexibility of federal direct loans and now parents are making payments during pre-retirement years.
Unless your child, say, becomes an engineer from a highly ranked college, there is no guarantee of a lucrative job offer right out of undergrad.
It makes more sense to take on a large amount of debt for graduate school, which can be all federal loans and is 100% in the student’s name. Plus, the student will obtain an MD, JD, MBA, or another degree that opens the door for much higher paying employment opportunities. If you or your child are interested in attending graduate school, I recommend reading this post on handling graduate school debt.
Bonus Tip of the Day
Make sure to encourage Grandma and Grandpa and other generous family members to open 529 plans to help with educational costs instead of buying the grandkids an Xbox or another such birthday gift. Your children may not appreciate that now, but they will after graduation where their monthly loan payment is only $250/Mo. instead of $500/Mo. because other family members helped with costs.
For many families, the high cost of higher education is a daunting proposition. The College Funding Coach is here to help. To learn more about paying for college while saving for retirement, register for one of our free workshops/webinars or speak with an advisor to get started on your college funding journey.