The Advantages of Student Loans

Borrowing to cover some or all of your family’s college costs could be the smartest wealth building strategy for many of you – and it recently became much more attractive. While it is comforting to pay the expenses from income or savings, that might not be the best way to continue building your family’s wealth. Even if you can write a check or sell investments to cover the education of a child or grandchild, take a look at the loans available.

Student loans aren’t the sweet deals they were before reforms in the 1980s and 1990s. But they have attractive features that might make them the best option for your family. Falling interest rates also makes borrowing for higher education even wiser.

There are several types of loans to consider for higher education expenses:

• Stafford Loans. These are loans taken out from either a local lender or directly from the U.S. Department of Education. They are guaranteed by the U.S. government. They can be subsidized or unsubsidized. The subsidy is that the government pays the interest during enrollment and the six-month grace period after graduation. The student has to qualify for financial aid to get this subsidy. But the interest rate, which is variable, is subsidized on all Stafford loans. The amount a student can borrow is limited. For example, the first year limit is $2,625, and it rises each year. 

• The Perkins Loan. These loans are given to the most financially needy students. They are awarded by a school’s financial aid office using money provided by the federal government. 

• PLUS loans. These Parent Loans For Undergraduate Students are federally subsidized and allow parents to borrow up to the total cost of undergraduate attendance minus financial aid received. Financial need is not required. The interest rate is variable – the 52-week federal treasury bill rate plus 3.10% – and is capped at 9%. Repayment begins 60 days after the loan is disbursed, and repayment can take up to 10 years. 

• Home equity loans. Of course, you can borrow against the equity in your home. Rates are fairly low, and the interest is deductible. 

Borrowing to fund higher education became more attractive recently because of lower interest rates and changes in the new tax law. Let’s take a look at how your family can use education loans to pay for education and increase family wealth.

Perkins loans are the best available. The interest rate is low, and many repayment options are available. If your family qualifies, take the Perkins loan. Even when the grandparents can afford to pay for a grandchild’s education, if the parent’s financial condition qualifies for a Perkins loan the family should take it.

The PLUS loans generally compete with home equity loans. PLUS loans are the only option if the parents don’t have enough home equity. But when home equity is available, borrowing against it might be the better choice. You can lock in a fixed rate on a home equity loan, the interest is deductible, and the interest rate should be comparable to the PLUS rate.The PLUS rate, which changes each July, is 6.79%.

Parents have to qualify for PLUS loans through private lenders. A lender can decide the parents have too much debt or too little income and decline to lend.

But the real advantages are with the Stafford loans, whether they are subsidized or unsubsidized. The loans are guaranteed by the government, so credit-worthiness is not a factor. The interest rate also is low. The rates are variable and adjusted every July 1 based on market rates. The newest rates on Stafford loans are 5.99% for loans in the repayment stage and 5.39% for borrowers still enrolled in school. Additional discounts are given to borrowers who maintain good repayment histories after college.

Though the interest rates are attractive, the big benefit of Stafford loans is the repayment. No payments have to be made until six months after the borrower stops being a student. In a subsidized loan, the interest before repayment is paid by the federal government. In the unsubsidized loan, the interest before repayment is capitalized and added to the loan balance.

Your family probably is best off if the student borrows in his or her name. Then the parents and grandparents take the money that would have gone to tuition and keep it invested.  Many investments will earn more than the Stafford loan rates over the college years, and the earnings will compound. By having the student borrow in his or her name, the student establishes a good credit rating faster after graduation.

After graduation, there are a number of payment options. If you had the money to pay for college, you can take it and pay off the Stafford loans in a lump sum. Or you can choose one of the many repayment options available. These include:

• The standard repayment plan has equal payments over up to 10 years. 

• The payments can be extended up to 30 years with equal payments. 

• The repayments can start low and increase over time. The minimum payment must at least equal the monthly interest that accrues, and the borrower will end up paying more interest over the loan’s life. 

• Income sensitive payment schedules tie the repayments to the borrower’s income with annual adjustments. 

• Those who borrower directly from the government can set payments based on a combination of the borrower’s current income and debt level. 

Loans also can be consolidated after graduation. The advantages of consolidation are that the variable rate loans are converted to a fixed rate, and all the loans from the college years are rolled into one. All or only some loans can be consolidated, and all of the repayment options are available for consolidated loans. But consolidation is allowed only once.

The new tax law also makes student loans more attractive. A deduction is allowed for interest paid on student loans, and the deduction is “above the line.” That means instead of being an itemized deduction, it is deducted on the front page of the tax return before arriving at adjusted gross income.

The deduction is limited to $2,500 per year. But the new law repealed the rule that allowed interest deductions on college loans only for five years. Now the deduction is allowed for as long as payments are made.

The new law also allows the deduction for more taxpayers. The full deduction is allowed for single taxpayers with adjusted gross incomes of $40,000 (phasing out for incomes up to $55,000) and married couples up to $60,000 (phasing out up to $75,000).

You can see several advantages to using student loans to pay for some or all education expenses. The interest rate is subsidized, and payment don’t begin until six months after the student graduates.That lets you put your other income and assets to work earning at least the same return as is charged on the loans.

After graduation, the interest rate still is below market rates. Repayment can be stretched up to 30 years. In addition, even if the parents or grandparents provide the money for the payments, the student builds a credit rating faster by having the loans in his or her name.

If you decide to take out student loans, choose a lender carefully.

You are allowed to borrow only from a lender in either your state of residence or the state in which the student attends college. Lenders in some states, such as Rhode Island and Maine, offer additional discounts beyond the federal subsidy to anyone who goes to college in their states. So if the student goes to college out of state, be sure to check lenders in that state and in your state.

Ask prospective lenders about special rates. Some lenders offer discounts if payments are made through direct checking account deductions. Others offer discounts for good repayment histories.

Most importantly, ask how interest during the college years will be capitalized. It can be capitalized quarterly, semiannually, annually, or at repayment time. The more frequently it is capitalized, the higher the eventual payments will be. So, you prefer that it not be capitalized until repayment time and really want to avoid a lender that capitalizes quarterly.

You also can borrow directly from the federal government. Compare those terms with those of private lenders.

There are numerous sources of information about student and parent loans, especially on the Internet. Start with the Department of Education web site, www.ed.gov. Sallie Mae, now USA Education, guarantees the student loans. Its site is www.salliemae.com. The largest private student lender is Citibank, and its site is studentloan.citibank.com. BankAmerica runs a site, www.finaid.com, that offers good overviews of all the lending options. Also check collegeboard.com.

Paying For College Without Going Broke by Kalman A. Chany has a good chapter on the loan programs and how to borrow. You also can get information from a college financial aid office and any local lender that makes either Stafford or PLUS loans.

With subsidized interest rates and generous repayment terms, borrowing to pay for college can be a smart financial move, even for parents and grandparents who have the savings or income to write the checks. Your ability to tap the available loan programs is another asset you can manage to increase family wealth.

Next month I’ll wrap up this series on financing higher education with a summary of the best choices between investments, financial aid, and loans.