Students embarking on the task of planning for how to finance their college education face a complex, and at times, bewildering array of options. But for the majority of students entering higher education programs, navigating that landscape is a necessary step. According to the National Center for Education Statistics (NCES), 66 percent of undergraduate students took some form of financial aid in the 2007-2008 academic year, the most recent year that figures are available.
The soaring price of college isn’t helping. Over the decade from the 1998-1999 academic year to 2008-2009, the cost of tuition, room and board at public institutions spiked 32 percent to $12,283 annually, according to NCES. At private schools, the cost increased 24 percent to $31,233. Both percentage increases are adjusted for inflation.
The good news for students is that they have many options to help foot the bill for their college education. While there is an abundance of scholarships and grants–both federal and private–to help finance a college degree, there simply isn’t enough “free money” to go around for everyone who needs financial assistance. For most students, that means they will have to borrow. To help demystify that process, we offer a quick overview of the three principal loan types, and three important facts to know about each.
Federal student loans
The primary loan the federal government issues to students is the Stafford loan. Stafford loans have maximum annual limits, and are broadly available, meaning that they are awarded both to students who can demonstrate financial need and those who cannot. The Stafford loan’s only eligibility requirement is that students be U.S. citizens or permanent residents. Students must maintain a GPA of at least 2.0 to keep receiving the loan disbursement throughout their college career.
The federal government also offers the Perkins loan program, which is only available to students who are in the most financial need, and carries more favorable terms (interest rate, cancellation provisions) than the Stafford loan. There is a much smaller pool of federal money for Perkins loans than Stafford loans, so availability is far more limited. (It is worth mentioning that the Obama administration is advocating a dramatic increase in the size of the Perkins loan program as part of its education agenda, but the issue has yet to be taken up in Congress.) Both loans carry repayment terms of 10 years.
Parent PLUS loans
The other primary federal student loan program, the Parent Loan for Undergraduate Students, known today as Parent PLUS, is a loan issued directly to parents for their child’s education. The federal government also lends money to graduate and professional students under this program in what are commonly known as Grad PLUS loans. Like the Stafford and Perkins loans, loans issued through the Parent PLUS program have lower interest rates than those generally available through private lenders, which experts say makes the federal government the preferred starting point for students and their families looking to borrow to pay for college. “First thing with regard to loans is they should always borrow federal first,” said Mark Kantrowitz, the publisher of FinAid.org, a comprehensive website with information about financial assistance for students. Parent PLUS loans also have a repayment term of 10 years. All students seeking to obtain federal tuition assistance must complete the Free Application for Federal Student Aid (FAFSA).
Financial assistance from private lenders accounts for a small portion of the overall lending picture. FinAid estimates that some $100 billion in federal loans are issued each year, compared with just around $10 billion in loans coming from the private sector. Also, loans issued by private lenders typically carry higher interest rates and less flexible repayment options. In the event that the borrower’s finances sour during the repayment term, for instance, it is much more difficult to negotiate payment deferments from a private lender.
At the same time, many private lenders offer repayment terms longer than the 10-year standard of federal loans, though the flexibility of the government’s terms can enable borrowers to extend that window. Kantrowitz advises against students and their parents against leaning too heavily on private or Parent PLUS loans after maxing out their eligibility under the Stafford loan program. “That’s a pretty good indication that you may be over-borrowing,” he said.
3 points to note about Stafford loans
Interest rates: As noted above, federal loans are advantageous over private loans because they carry low, fixed interest rates. Interest rates on Stafford loans are set at 6.8 percent. The need-based Perkins loans, by contrast, are set at 5 percent.
Subsidized vs. unsubsidized: The Stafford program issues loans in two forms: loans that are subsidized and those that are unsubsidized. The term “subsidized” refers to the way interest payments are assessed while the student is in school. With a subsidized loan, the federal government pays the interest while the student is in school. To qualify for a subsidized loan, the student must demonstrate financial need. With an unsubsidized loan, students are responsible for the interest that accrues during the time that they are in school, though they can choose to defer payments until after they graduate. Students should know that by deferring, the accrued interest will be added to their repayment balance after they graduate, increasing the overall size of the loan.
Maximum borrowing limits: Stafford loans are capped at a maximum borrowing limit. Dependent students can borrow up to $5,500 annually for their first year of college, $6,500 for their second year and $7,500 for their third and fourth years and beyond, up to a maximum cumulative cap. Parent PLUS loans, by contrast, have no cumulative cap. Students whose parents have been denied a Parent PLUS loan are eligible for higher annual loan amounts through the Stafford program.
3 points to note about Parent PLUS loans
Credit check: Unlike Stafford loans, Parent PLUS loans require a basic credit check. The credit check and lending standards are less rigorous than what borrowers will encounter with private lenders, as the check only scans for what is known as an “adverse credit history,” and covers major events such as recent bankruptcy or tax liens.
“Generally speaking if you’re denied a Parent PLUS loan you’re not going to get a private student loan,” Kantrowitz said.
Best used to augment Stafford loans: The current interest rate for Parent PLUS loans is 7.9 percent. Because the rate for Stafford loans is lower, experts advise families to take out the maximum available under that program before taking out a Parent PLUS loan, noting that there is nothing stopping parents from making the payments on their child’s Stafford loan. “Obviously you want to max out the student loans first because they have lower rates,” Kantrowitz said. FinAid reported that in 2007-2008, 8.2 percent of Parent PLUS borrowers did not take out a Stafford loan, and 33.2 percent borrowed less than the maximum amount.
Parents are on the hook: Since this loan is issued to the parents, they are considered the borrowers and are ultimately responsible for the repayment, even though many families arrange for students to help repay the loan. Repayment begins 60 days following the disbursement of the final payment, and can be extended for up to 10 years. Interest on PLUS loans is not subsidized. Parents seeking a PLUS loan are advised to contact the financial aid office of their child’s school.
3 points to note about private loans
Variable rates: As noted above, both varieties of federal loans come with interest rates lower than those generally available today through private lenders. In addition, the rates on private loans commonly have variable rates that fluctuate with an index to which they are tied, meaning that the rate could potentially increase over the course of the repayment term. The interest rates private lenders attach to a loan are also influenced by the applicant’s credit score, and they offer little insight into how the rate is determined. “The lenders don’t publish that information; it’s proprietary. The only way to know what interest rate you’re going to get is to apply,” Kantrowitz said. “There’s no up-front advertising.”
Higher credit barriers: Private lenders have much more stringent requirements for borrowers than the modest check involved with the federal Parent PLUS loan. That means that the lending institution will check the borrower’s FICO score (the most common expression of a credit score) and debt-to-income ratio — both factors that don’t affect Parent PLUS loans.
Kantrowitz said that historically the minimum FICO score required for a student loan has been around 650, “but I’ve seen students with 780, 790 scores get denied.” He explained that the private student loan market is still weighed down by the fallout from the subprime mortgage crisis and the broader economic recession, creating a stingy climate for borrowers. “The private market is still liquidity-constrained. A lot of these lenders have more demand for the loans than they have funds available,” he said. “I think we’re still a few years away from when lenders start dropping their credit criteria.”
Apply with a cosigner: Many students can and do obtain college loans from private lenders on their own, but they improve their chances if they have a parent co-sign the application. That will increase the likelihood of approval of a loan at a lower interest rate, as shared responsibility for the loan decreases the lender’s risk. Additionally, lenders typically base the terms of the loan on the higher of the two applicants’ credit scores, so a parent with excellent and established credit who cosigns for the loan could result in a dramatically reduced rate.
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