If you have a child or grandchild who is beginning college soon, you’re probably aware that in addition to academic readiness, preparing for college requires a financial strategy – especially as the cost of higher education continues to rise rapidly. Today, the average debt for graduates who fund their education with loans tops $25,000, and that number is expected to rise. 1
Unfortunately, many young people heading into the world of higher education – and borrowing to pay for it – may not fully appreciate the financial challenges that lie ahead. At a young age, it seems simple to borrow money with the expectation that the loan repayments will be manageable, but too often students experience setbacks during their college career or after graduation that makes repayment more difficult than anticipated. With all the conflicting information and opinions out there, it’s important to understand the basic considerations that go into borrowing to pay for college.
Not all loans are created equal
Loans that are available to fund education costs can be categorized in two distinct ways. Federal loans are those issued directly by the federal government, while private loans are provided by banks and other private lenders. For most people, federal loans will offer the most favorable terms in the long run. But if money provided by federal loans is not sufficient, students may need to also consider private education loans.
Federal loan basics
There are three primary types of federal student loans:
- Stafford Loan – These loans can be “subsidized” or “unsubsidized.” A subsidized loan means that the interest charged on the loan is waived while the student is enrolled in school and for a period of time after graduation. Unsubsidized loans calculate interest accrued from the time the loan is given. These loans charge a fixed rate of interest, but are not likely to be sufficient to cover the full costs of higher education.
- PLUS Loan – This type of loan is available to creditworthy parents of dependent undergraduate students lent at a fixed interest rate. It can be used to pay the remaining balance of education expenses not covered by a Stafford Loan or other forms of financial aid. Graduate and professional students can also qualify for this form of aid.
- Perkins Loan – This loan program is not available through all schools. Educational institutions must choose to participate. It provides five percent fixed-rate loans made directly by the school to the student using federal government funds. This is typically reserved for students with the greatest financial need.
Students can qualify for federal loans regardless of their credit history, and if the student were to lose his or her job in the future, the payments can often be deferred. Federal loans also have a six month grace-period before repayment begins that allows students extra time to find employment after they graduate which makes it less likely that their financial security will be jeopardized immediately after college.
Private education loan basics
Many banks and lending institutions also offer private education loans (also known as alternative education loans) to help pay for college. These can help bridge the gap between the actual cost of education and the amount available through federal loan programs. But before borrowing, families should consider the following:
- Interest rates on private loans tend to be variable, which means they may increase in the future. Depending on the amount borrowed and the repayment schedule, they could ultimately end up being more costly than federal loans, even if they initially carry a lower interest rate.
- A co-signer is often required for a private loan. The co-signer presumably has a more substantial credit history than the student and will be required to pay for the debt if the student fails to do so. Unlike with federal loans, the balance may not be forgiven if the student becomes disabled or dies.
- Deferment may not be an option if the student is laid off or faces financial hardship while trying to find a job, and default can be declared by some institutions if only a single payment is missed. This can do serious damage to the borrower’s and the co-signer’s credit ratings.
The most important thing that students and their families can do is to enter any loan agreement with a firm understanding of how the structure of the repayment agreement works, and to develop a back-up plan in the case that the student isn’t able to make loan payments for any reason. It’s also crucial that students recognize how their student loan debt may affect them in the future. A college education is significant in a student’s life and future career – and starting early with careful financial planning can make it affordable and less overwhelming. Consider working with a financial advisor who can help parents and their students plan for the financial aspect of college. When it comes to student loans, a little financial education can go a long way.
1 According to a report published November 3, 2011 from the Institute for College Access & Success Project on Student Debt
Paul J. Fragala, CFP, CIMA, is a Financial Advisor with Ameriprise Financial Services, Inc. in Andover, MA. He specializes in fee-based financial planning and asset management strategies and has been in practice for 18 years. To contact him: www.paulfragala.com, 76 Main St., Andover, MA, (978)-474-9900.
Advisor is licensed/registered to do business with U.S. residents only in the states of MA, PA, MD, AZ, RI, FL, TX, DC, NY, SD, ME, CA, IA, OH, IL, NH, MI, NJ, NM, NC, VT, ND.
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