Paying for College Without Going Broke, 2017 Edition - Princeton Review, Kalman Chany (2016)
Part IV. The Offer & Other Financial Matters
Chapter 8. Managing Your Debt
For many people, there is really no choice; if you or your child want a college education, you have to go into debt. But it turns out that there are a number of choices to make about how you go into debt and how you eventually pay it off. Most parents and students assume they have no control over the loan process. Unfortunately, this assumption may cost them thousands of dollars.
In previous chapters we’ve discussed the different kinds of loans that are available. Of course, the most common types of loans are Stafford and PLUS loans.
In this chapter, we’ll provide more information on how to select the best loans, as well as how to pay off these loans once you are required to do so.
As usual, this advice comes with our standard caveat: We can’t recommend any specific course of action since we don’t know your specific situation. These strategies are only meant to steer you in the right direction. Please consult with your accountant or a financial aid planner.
Before You Borrow
Smart financial planning dictates that you always borrow at the lowest possible cost. So the first type of loan to consider is usually the federal Perkins loan- a 5% fixed-interest rate loan made to the student; interest is subsidized while the student is in school, and during a 9-month grace period after the student leaves school, graduates or drops below half-time status. (We’ve already given some details on loans on this page-this page.) The Perkins loan is available to graduate as well as undergraduate students.
For undergraduate students for the 2016-2017 academic year, an even better loan is the subsidized Stafford loan. For Stafford originated during the 2016-2017 school year, the rate will be fixed at 3.76% for the life of the loan. However, depending on the 10-year Treasury Note rate which will now determine the rate on any Stafford Loans originated on or after July 1, 2014, the rate on the Stafford may be higher or lower than the 5% Perkins loan rate for new Stafford loans originated after the 2014-2015 school year.
Yet even if the Stafford rate exceeds the Perkins rate in subsequent years, it is still a great deal since the government pays the interest on a subsidized Stafford while a student is in school. And if you wish to pay off a subsidized Stafford loan before the student leaves school, graduate or drops below half-time enrollment, no interest will be charged at all.
Next in desirability is the unsubsidized Stafford loan. Unlike the Perkins and the Subsidized Stafford, the unsubsidized Stafford loan charges the student interest from day one. The decision whether or not to take out this type of loan depends on other factors. For example, let’s say you have funds for school in a bank account that’s earning 1% in a bank; in that case, it makes no sense to take out a loan in which you’re paying more interest than you’re earning by keeping those funds in a bank. Conversely, if you don’t have the funds to pay for school, and other loans would carry a higher interest rate, then the unsubsidized Stafford makes sense.
And for paying the education expenses of a dependent undergraduate student, the last federal loan option available is the PLUS loan—in which one of the student’s parents is the borrower. With interest charged from the time the loan funds are disbursed at a fixed rate that is higher than the fixed rate for an unsubsidized Stafford, this is the costliest of the federal education loan options.
There are two other types of loans available which can be broken down into two categories: the first offered by state educational financing authorities such as MEFA in Massachusetts or CHESLA in Connecticut. Depending on the eligibility criteria, some of these loans allow state residents to borrow funds for schools both in-state and out-of-state. Some also make such loans available if an out-of-state student is attending a participating school within the state that offers the loan. Most have a fixed-rate option that is sometimes lower than some federal loan options. The second category involves private alternative loans, generally offered by banks or other private lenders. While these mostly variable rate-loans can start out lower than the Federal options, if interest rates rise appreciably they can become a very costly. And unlike housing debt, in which you can convert a variable rate home equity line of credit into a fixed-rate loan before interest rates start to rise, these education loans normally cannot be refinanced with another fixed-rate education loan.
But what if you’re an independent undergraduate student? The first three most attractive options offered above should be considered in the same hierarchy. Compared to most dependent undergraduate students, independent undergrads can borrow an additional $4000 for each of the first two years and an additional $5,000/year for the third year and beyond via the Stafford Loan program should additional funds be needed. But that’s it for federal education loans for independent undergrads, since there are officially no parents in the picture who can take out PLUS loans. Even if a parent of an independent undergraduate wants to take out a PLUS loan for their child, they cannot do so since PLUS loans are only for parents of dependent students.
What about graduate students? Beginning with the 2012-2013 academic year, graduate and professional school students are no longer be able to take out subsidized Stafford loans. They can still take out unsubsidized Staffords (up to $20,500 per year, and possibly even more for health profession students), but the up-to-$8,500 subsidized Stafford that existed in 2011-2012 and before is no longer available. However, all unsubsidized Stafford loans for graduate students will continue to have a fixed-interest rate—albeit at a higher rate than for undergrads. (5.31% for loans taken out in 2016-2017.)
Graduate School Considerations
Those considering going on to graduate school, which for purposes of this chapter will include any professional school such as a law school, medical school, business school (MBA) etc., should consider borrowing the maximum amount of Perkins and subsidized Stafford loans for which they are eligible as an undergraduate. This is because unless you’re fortunate enough to get a Perkins loan (and there’s only a limited amount of this money available to graduate students) any money you borrow will have interest charged from the get-go. So you would be better off preserving funds in your nest egg while the student is an undergraduate, and using them instead in graduate school when the cost of borrowing is higher.
And what if you’re stopping out for a few years between an undergraduate program and graduate school? With the subsidized Stafford no longer available to graduate students, one would be better off making minimum payments on their education loans, possibly by choosing a repayment option other than the standard one (which we’ll cover shortly). Provided you have the discipline.
When you go back to school, the amount of any subsidized Stafford and Perkins loans that qualify for an in-school deferment will be frozen at the amount owed when you return to school until you graduate, leave school, or drop below half-time status
So you’re better off stockpiling the cash for graduate school, rather than paying off these loans quickly. For two reasons: one, this will reduce your overall interest charges. And you’ll also minimize or even avoid origination fees on new loans by borrowing less for graduate school or not borrowing at all. And if you are borrowing less for graduate school, the weighted average of all the loans together will ensure a lower overall rate than if you pay off lower-interest loans early and then have to take out higher-interest loans such as the 5.31% unsubsidized Stafford or 6.31% Grad-PLUS loan (which we will soon discuss).
Note: For your prior loans to again qualify for an in-school deferment, you will have to go back to the holders/servicers of your prior federal education loans and let them know you’re back in school as well. You will also have to meet all other criteria based on your enrollment status. Each loan holder/servicer will send you a form to be completed by the school you will be attending, so that you’ll again be eligible for the in-school deferment to suspend payments while in school and so that the government will again pay all the interest on any subsidized Stafford and Perkins loans while in school.
Graduate / Professional students are eligible for three federal student loans: the Perkins loan, the Stafford loan, and the GradPLUS loan (which is a student loan that works similar to the parent PLUS in that one can borrow the total cost of attendance minus any other aid received including other student loans.) So if the Perkins and Stafford loans are not sufficient, graduate students can use the GradPLUS loans to cover their additional costs. Unlike independent undergraduate students, graduate and professional students can therefore borrow their entire cost of attendance via the federal education loan programs if no other aid is awarded. Note: Similar to a parent taking out a PLUS loan, a student borrowing through a GradPLUS loan must pass a credit test or have an eligible credit worthy cosigner to obtain the loan (per this page). Perkins and Stafford loans do not require any such credit test.
As mentioned earlier, the Perkins loan program may be eliminated or experience changes that will make it less attractive for new loans.
How to Pay Off Your Loans
As soon as a student graduates, the clock starts ticking. The government gives you a six-month grace period to find a job and catch your breath—and then the bills start arriving. You might think that at least this part of the process would be straightforward: they send you a bill, you pay. But in fact, there are a bewildering number of repayment options, as well as opportunities, to postpone and defer payment.
Overriding all of this is one simple maxim: The longer you take to pay, the more it costs you. Putting it in practical terms, choosing to lower your monthly payments will stretch out the amount of time you’ll be making these payments, and ultimately add thousands of dollars in interest to your bill. Sometimes this is worth it, as we’ll see.
It’s impossible for us to predict exactly what your monthly payments will be, since everyone owes different amounts, and borrowed on different terms. Just to give you a ballpark figure, someone who owes $15,000, at an average rate of 8% would have 120 monthly payments of about $182. Someone who owes $50,000 would have 120 monthly payments of about $607.
The only way to defer these student loan payments long-term is to stay in school. As long as you are at least a half-time student at an approved post-secondary school, you can keep those bills at bay forever. If you get a job and then later decide to go on to graduate school, your loan payments may be deferred while you are in graduate school, and resume as soon as you get out.
Above All, Avoid Default
When all the loans come due, and a few personal crises loom as well, there’s a very human urge to shove the bills in a drawer and hope for the best. This is absolutely the worst possible thing you can do.
The default rate on government guaranteed student loans is still somewhat high at the moment. This might give you the erroneous impression that a default is no big deal. You should realize that a large portion of defaulted loans comes not from college loans, but from loans made to students of “bogus” trade schools with three initials and two faces. These trade schools are often scam operations designed to fleece the federal government by preying on immigrants and poor people. A new arrival to this country may not care about or understand the importance of his credit rating, but you certainly do.
When people get into economic trouble, they tend to get very reticent, and often don’t ask for help. Even though you may feel embarrassed, it is much better to call your lender and explain the situation than to miss a payment with no explanation.
As you will see, there are so many different payment options, that there is really no need for anyone ever to go into default. If you lose a job, or “encounter economic hardship,” you should apply for a temporary deferment (suspension of principal and interest payments for a specified time) or something called forbearance, which can include temporary suspension of payments, a time extension to make payment—even a temporary reduction in the amount of monthly installments. Many lenders will draw up new repayment plans, or accept a missed payment as long as you inform them ahead of time.
Work with the lender. Or rather, lenders. If you have loans from more than one lender (the Perkins loans are administered separately from the Stafford loans), one lender isn’t necessarily going to know what’s happening with the other, unless you tell them.
It can take years to build up a good credit rating again once you’ve loused it up. Meanwhile, you may not be able to get credit cards, a mortgage, or a car loan. And if you’re in default, getting additional loans for graduate school can be difficult if not impossible.
The Different Payment Plans
If you are repaying Stafford loans, Supplemental Loans for Students (SLS), PLUS or Grad PLUS loans, there up to seven repayment options at present. When you pick an option, it is not for life. You can switch payment plans at any time. Here is a brief summary of the options. For more details, contact your lender(s).
Standard repayment: The loans must be repaid in equal installments spread out over up to 10 years. This is a good plan for people who have relatively little debt, or have enough income to afford the relatively high payments.
Extended repayment: The loans must be repaid in equal installments over a period that can extend up to 25 years. The increased time period reduces monthly payments, but long-term interest expenses go up dramatically.
Graduated repayment: Loan payments start out low and increase over time. The payments must always at least equal the monthly interest that’s accruing. This is a good plan for young people whose earnings are low, but are expected to increase over time. Over the lifetime of the loan, interest expenses are much higher.
Income-sensitive repayment: This option allows payments that are initially low, but increase as income rises. The lender works with the borrower to establish a payment schedule that reflects the borrower’s current income. The payments are adjusted annually to accommodate changes in the borrower’s income. This option is available only to borrowers who took out Stafford, PLUS or Grad PLUS loans from private lenders years ago.
Income contingent repayment: This option is available only to borrowers with federal Direct Loans, but does not cover parent PLUS loans. In this plan, the payments are based on a combination of the borrower’s level of debt and current income. With this (and the following two options), payments can be lower than the monthly interest accruing (which is called negative amortization). Of course, this can add substantially to the final cost of long-term interest expenses. To counter this, at the end of 25 years, the government will forgive any unpaid balance. But don’t start jumping for joy: the IRS may tax you on this unpaid balance. Thus, if the government were to forgive a $10,000 remaining debt, a person in the 25 percent tax bracket would have to come up with at least $2,500 in additional taxes that year.
Income-based repayment and Pay As You Earn: Under these options, the required monthly payment will be based on your income during any period when you have a partial financial hardship. The monthly payment may be adjusted annually. The maximum repayment period under these plans may exceed 10 years. If you meet certain requirements over a specified period of time, you may qualify for cancellation of any outstanding balance. The amount of any loan canceled may be subject to income taxes. Parent PLUS Loans are not eligible. Only Direct Loans qualify for Pay As You Earn.
Government regulations allow you to consolidate all your education loans from different sources into one big loan—often with lower monthly payments than you were making before. As usual, the catch is that the repayment period is extended, meaning that you end up paying a lot more in interest over the increased life of the loan. However, you can always prepay your loans without penalty.
The loans that can be consolidated are: the Stafford, SLS, Perkins, PLUS loans, Grad PLUS loans, and loans issued by the government’s programs for health-care professionals. You can’t consolidate private loans from colleges or other sources in the federal consolidation program.
How It Works
A consolidation loan can be paid back using one of the plans outlined above. In some cases, loan consolidation doesn’t make sense—for example, if you are almost done paying off your loans. For the most part, student loans can be consolidated only once, and in most cases, it would be better to wait to do this until a student is completely finished with school.
You also don’t have to consolidate all your loans. The rules on how your new interest rate will be calculated change constantly, so you’ll need to get up-to-date information from your lender.
Before you consolidate any loans, you should also consider these factors:
✵ How will the interest rate be calculated?
✵ Are you better off excluding some loans from consolidation to get a better rate and/or to prevent the loss of some benefits with some of your loans?
✵ Will consolidating your loans later give you a better or a worse interest rate?
✵ Can you consolidate your loans(s) more than once?
✵ Do you have to consolidate your loans with a private lender? Do you have to consolidate your loans directly with the government? If you have a choice between the two, which consolidation plan is the best deal for you?
✵ If you are consolidating unsubsidized and subsidized loans together, will this affect your ability to have the government pay the interest on your subsidized loans should you go back to school?
Loan Discharge and Cancellation
The Perkins Loan program, and to a lesser extent, the Stafford and PLUS loan programs have various provisions in which the loan can be discharged or canceled. While some provisions hopefully do not happen to you in the near future (e.g. you become permanently disabled or die), loans may also be forgiven for performing certain types of service (teaching in low-income areas, law enforcement, nursing, working with disabled or high risk children and their families in low-income communities, etc.).
One of the provisions of the College Cost Reduction and Access Act has expanded Direct Stafford loan forgiveness in exchange for public service. Borrowers who take public sector jobs in the government, the military, certain non-profit tax-exempt organizations, law enforcement, public health, or education, may be eligible—after making 120 on-time payments after October 1, 2007—to have the remaining balance of their Direct Loans forgiven.
Those with Stafford loans borrowed through banks (not borrowed through the Direct Loan program from the government through the financial office of your school) may be able to take advantage of this new provision by consolidating, or even re-consolidating, into a Direct Consolidation Loan.
Keep in mind, however, that under the current tax code, the amount of a loan that is forgiven is considered taxable income in the year in which it is forgiven. There is some talk in Washington that such public service loan forgiveness may be made exempt from such taxation through additional legislation. Of course, if this happens we will cover it in future updates.
The Smartest Loan Strategy: Prepayment
All federally guaranteed education loans can be prepaid without any penalty. This means that by paying just a little more than your monthly payment each month, you can pay down the loan much faster than you might have thought possible, and save yourself a bundle in interest.
Obviously, if you’re going to do this, try to prepay the loans with the highest interest rates first. It wouldn’t make sense to prepay your 5% Perkins loan if you’re paying 10% on an unsecured bank loan, or 12% on some huge credit card bill.