Families who borrow money to pay for their children's higher education expenses usually do so reluctantly, and only after all liquid assets have been exhausted.
But taking out loans before spending savings may be a smarter strategy, especially in light of recent changes to the terms under which families receive and repay some of the debt that's used for college costs. Here is why clients with kids in college should fill out a loan application before they whip out their checkbook.
First, since there is no vehicle that allows clients to borrow money to retire, it's essential that parents devote their attention and their dollars to socking away money into IRAs and 401(k)s.
Getting a loan for college also ensures that some financing is obtained under today's relatively favorable rates and conditions. Then if interest rates rise in the future, or loans become more difficult to get, the savings can be deployed.
Finally, that well-kept cash will come in handy if a family ends up facing a financial emergency even more serious than “paying for college,” and needs to redirect the money toward getting through the crisis.
Payback isn't that bad
Many clients will savor the idea of preserving their savings while still sending their kid to college. But an equal number might blanch at a loan payment schedule that could last until their death, or until their child reaches middle age.
It's a reasonable concern, but the clients' fears may be greater than the facts. Most student loans can be paid off in 10 years if the monthly payment is at least 1 percent of the original balance.
True, that works out to about $3,000 per year. But it's miniscule when weighed against the several hundred thousand dollars of lifetime earnings that college graduates typically earn, compared to those whose formal education ends with a high school diploma.
The best loans to use
Most families first should consider federal student loans, which usually offer lower interest rates, less onerous application processes, and more flexible repayment terms than what private lenders provide.
Perkins Loans are need-based, and provided by the school. The interest rate is 5 percent, and for 2010 the annual maximum that can be borrowed is $5,500 for undergrads, and $8,000 for graduate and professional students.
Direct Subsidized Stafford Loans are also need-based, and offered “directly” from the federal government. The interest rate is 4.5 percent for undergraduates, 6.8 percent for post-graduate programs; repayment doesn't kick in until the student leaves school. The maximum yearly amount ranges from $3,500 to $8,500, depending on the student's grade level.
Direct Unsubsidized Stafford Loans aren't need-based, and charge 6.8 percent interest at all levels of schooling, beginning as soon as the money is disbursed. The annual limit runs from $5,500 to $20,500, depending on grade level and status of dependency.
Direct PLUS Loans are offered to parents of dependent students, and directly to those pursuing graduate and professional degrees. Interest is 7.9 percent, and it begins accruing immediately. The maximum amount is the cost of attendance, minus any other financial aid awarded.
There are a couple items to note for families planning to borrow. First, since the most favorable loans are capped at an annual amount, families should borrow what they can each year before considering most other sources.
Second, in many cases the actual cost of a year of college will greatly exceed the annual amount available from the optimal programs. Therefore, families may still have to (and probably should) consider using private lenders or home equity before eventually cashing in their savings.
Borrow more, pay less
The biggest advantage to using federal loans is that the ones obtained by students may not have to be repaid in entirety, especially if the monthly loan payment proves to be too much for an un- or under-employed college graduate to handle.
The Income Based Repayment Program is available to students with outstanding federal loans, obtained through either the Direct or Guaranteed Loan program.
The process calculates a minimum required payment that is usually no more than 15 percent of monthly income, after a basic living allowance. For instance, if a borrower is single with no children, owes $50,000 in qualifying loans, and earns $25,000 per year, she could stay current in her loans as long as she paid at least $110 per month, according to the calculator available at www.ibrinfo.org.
If she makes those payments on time for 25 years, any unpaid balance left at that time will be completely forgiven, regardless of the balance. For money borrowed after 2014, the minimum monthly percentage of income required for repayment drops from 15 percent to 10 percent, and any balances left over after 20 years of steady repayment are forgiven.
Another way students may be able to get out from under higher education debt is through a new program called Public Service Loan Forgiveness (PSLF). Under PSLF, students who have federal loans, work full-time in qualifying occupations, and make minimal monthly payments may be able to get the debt forgiven after 10 years.
The qualifying occupations include those offered by non-profits, education, and law enforcement, as well as positions in local, state, and federal government.
Start the process now
There are three steps that clients can take right now to maximize their options to borrow money for higher education expenses.
They can start by checking their (and their child's) FICO scores at www.myfico.com. Since some loans may require a credit check, peering into their credit reports now offers more time to fix any errors and to improve the overall score.
If the clients have home equity, they should consider establishing a new 30-year fixed-rate mortgage for as much as the lender will allow. Any “cashed-out” proceeds should be tucked safely away for a rainy day.
Families with children attending college should fill out the government's financial aid form (the “FAFSA”) each year, as soon after Jan. 1 as possible. The form is available at www.fafsa.ed.gov, as well as a few “dry run” calculators available at www.finaid.org.
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.advisortipsheet.com.