Your Financial Future:
Student Loans 101
For a PDF version of this Fact Sheet, click here.
One of the most important investments you can make is to invest in your education. The U.S. Census Bureau reports that in 2007, those with a bachelor’s degree earned approximately $20,000 more than those who only held a high school diploma. By investing in your higher education, you are essentially investing in a more secure financial future. However, college is expensive. You may be worried about how you will pay for it. There are many different options to consider.
Many people take out student loans to help them pay for college. There are two types of student loans available: federal government loans and private loans.
- Federal Government Loans generally have low interest rates. Furthermore, you usually do not have to start paying back the loan until after you leave school. There are several federal government student loan programs available.
- Stafford Loans make up the majority of student loans. You can obtain these loans in one of two ways. You can get it from a private lender like a bank, who administers the loan through the Federal Family Education Loan (FFEL) Program. You can also get the loan directly from the Department of Education, through the Federal Direct Loan Program. The type of Stafford loan you get—either a FFEL or a Direct Loan—is based on what program your school participates in. Although you don’t have a choice on what Stafford loan you receive, it is the government, not the issuing institution, who sets the rules concerning interest rates and terms of repayment on the loan. Stafford loans can be subsidized or unsubsidized. A subsidized Stafford loan is offered to students based on demonstrated financial need, and the government pays all interest that accrues on this loan while you are in school. If you have an unsubsidized Stafford loan, you are responsible for paying all the interest on the loan, even while you are in school (although payments can be deferred).
- Parent PLUS Loans are federal loans made to students’ parents. Rates on these loans are generally higher than Stafford loan rates, but they are a much better deal than private loans. They also allow your parents to borrow up to the full amount of your tuition, fees, room and board and other living expenses with the option of deferring payments for six months. These loans are an option for your family as long as your parents have not had any major credit problems such as bankruptcy or foreclosure.
- Grad PLUS Loans are similar to Parent PLUS loans except that they are loans made to graduate students. If you are planning on attending graduate school, you can take out these fixed-rate loans to pay for tuition and other expenses. In order to qualify, all you need is a decent credit record.
- Perkins Loans are low-interest federal loans for students who come from low-income backgrounds. Unlike the Stafford loan and the PLUS loans, the Perkins loan is made through your school’s financial aid office. Although the funds come from the federal government, your school is the lender so you must repay this loan to your school.
- Private Loans, also known as alternative loans, come from banks and other financial institutions. Because their interest rates are generally not capped and thus can potentially keep rising, these loans are usually much more expensive for borrowers. In fact, private loans generally charge twice as much interest as federal student loans. You should view private loans as a last resort, turning to them only if you cannot get a federal loan. If you already have private loans with high interest rates, you can try combining them into a new private consolidation loan at a better rate. Alternatively, you could get a cosigner with good credit to apply with you for a new lower-rate loan.
How can I reduce the cost of my student loans?
Some loan servicers will reduce your interest rates or reward you a modest sum if you sign up for electronic payment or consistently pay your bills on time.
- If you prepay your student loans, thereby paying them back faster than you need to, you will be paying less interest over the long run.
- The government gives a tax break to students who are paying off student loans, so you may be able to deduct interest payments on your student loans. You must file form 1098-E to get this tax break.
Tips on Student Loan Repayment
- If you have multiple loans with the same lender, you can simplify your payments through loan serialization (or unified billing), which is where your lender sends you just one bill for all of the loans that you have with them. Although your loans won’t change, receiving just one bill every month as opposed to multiple bills could help you stay organized and be prompt with your payments.
- If you are struggling with high interest rates, consider loan consolidation, which combines all of your loans into one with a new, averaged interest rate that is typically lower than what you are paying. Check with your loan servicer to see if it offers consolidation, or try the Federal Direct Loan Consolidation Program.
- Standard Repayment: The standard way to pay back student loans is to make equal monthly payments for ten years. Generally, monthly payments under this plan are higher than it would be under other plans because your loans would be paid off in the shortest amount of time.
- Extended repayment: If you owe a lot of money in student debt, this may be a better option for you because you are able to stretch your payments out over a period of 12 to 30 years. Although your monthly payments will be smaller under this repayment plan, you will end up paying more in interest because it will take longer to repay your loans. Generally, the amount of time you’ll be allowed to extend your payments is based on the amount of money you owe.
- Graduated repayment: This option allows you to pay less in the early years of your loan, with your payment amount increasing every two years.
- Income-based repayment: Allows you to pay a set percentage of your income every month.
- Deferment: If you are unemployed, a student, or have a full-time unpaid position, you might qualify for a deferment that allows you to put off repaying your student loans for a certain period of time.
If You Have Both Credit Card and Student Loan Debt
Because credit cards tend to have higher interest rates than student loans, it usually makes more sense to pay off your credit card debt first. One option is to reduce your monthly student loan payment by extending the life of your loan over a longer period of time, thereby freeing up some cash to pay off credit card debt. Later, after you have paid off your credit cards, you can bring your student loan payments back up to their original levels. However, a note of caution: any extended repayment options you choose will lead to paying more in interest in the long run.
There are a number of programs that allow you to cancel a portion or all of your student debt after a certain period of time. If you teach or work in health care in a low-income area, work in public service, join the Peace Corps, or enlist in the military, the government or your lending agency may forgive your loans. For more information, visit:
- The American Federation of Teachers (http://www.aft.org/) and AmeriCorps (http://www.americorps.com/)
- The National Health Service Corps (nhsc.bhpr.hrsa.gov)
- The Peace Corps (http://www.peacecorps.gov/)
- The Student Loan Repayment Program (http://www.military.com/).
Furthermore, on July 1, 2009 the Federal Student Loan Forgiveness Law went into effect. The act lowers monthly student loan payments through Income Based Repayment (IBR), which aims to ease financial strain on low-income borrowers with high debt. You qualify for IBR if you have a federal loan, however, there are a few exceptions. For more information, go to www.ibrinfo.org or www.finaid.org/calculators/ibr.phtml.
Other Ways to Save for College
Coverdell Education Savings Accounts (ESAs)Replacing the Education IRA, the ESA was created as a way for parents to save for their children’s education. Up to $2,000 per year can be contributed to a child’s account, until that child turns 18. The money in the account can be invested in stocks, bonds, mutual funds, or cash equivalents.
- Benefits to an ESA
- Similar to a Roth IRA, ESA contributions are not tax-deductible, but account savings or investments are allowed to grow tax-free, which significantly increases total returns.
- In order for withdrawals to be tax-exempt, the money must be spent on education-related expenses only. However, spending is not limited to college expenses. Money from ESA accounts can also be used for certain elementary and secondary school expenses such as private school tuition, tutoring, and computers.
- You can get an ESA through any financial institution that normally offers IRAs, such as a bank, credit union, or mutual fund company.
- Drawbacks to an ESA
- If you are the “owner” of the account, the assets in the ESA may greatly reduce or make you ineligible for financial aid for college.
- If the ESA is invested in a mutual fund, there is usually an annual fee to maintain the account. According to experts, those fees can be as much as $35 a year, which would be 7% on a $500 contribution.
State 529 Plans
Named after the section of the IRS code that governs them, 529 investment plans are designed to help families save for college. The money in the account can be used at any accredited college or university as well as certain foreign schools. Each state has its own 529 plan, so if you don’t like your state’s plan, you can choose another state’s plan (although you should watch out for extra fees or missed tax advantages). There are two kinds of 529 plans:
- Pre-Paid Tuition Plans: These allow your parents to lock in today’s tuition rates by purchasing credits for future tuition and sometimes even room and board at in-state public colleges. Amounts of tuition can be purchased (in years or units) through a one-time lump sum or through monthly installment payments. The program then pools the money from everybody and makes investments to enable the earnings to meet or exceed college tuition increases in your state.
- College Savings Plans: Contributions go into one or more investment portfolios offered by the plan. Portfolios are managed either by the state or, increasingly, by large money management or investment firms. Investment portfolio options are typically sorted out by type of security held and associated level of risk. For example, you can choose riskier portfolios largely made up of stocks, which offer more growth potential, or safer fixed-income investments such as bonds, with a lower earnings rate. Some state plans are “age-adjusted,” meaning that the risk level of the investments is adjusted depending on how far from college the child is, to allow for higher returns when they are still young and more stable investments when they are getting closer to college age. If possible, avoid using a broker, as they will charge you extra fees.
Benefits to 529 Plans
529 savings plans allow dramatically higher annual contributions compared to Coverdell ESAs. The limits are established by each state’s program, but it can exceed $300,000 per beneficiary, versus the ESA’s $2,000 a year limit.
- The 529s do not have an income limit for making contributions.
- Since the account stays in the contributor’s name, the beneficiary can be changed within the family, including first cousins. Any unused amounts can be rolled into another 529 for someone else.
- Though contributions are taxed, earnings grow tax-free and withdrawals to pay for college costs are exempt from the federal income tax.
- 34 states and the District of Columbia allow a state tax deduction for contributions to a 529 plan. For most states, you have to live or work in the state and choose its plan in order to qualify. Residents of Pennsylvania, Arizona, Maine, and Kansas are offered tax deductions even if the 529 plan they participate in is out of state.
- The Federal Direct Loan Program: Call 800-848-0979 or go to http://www.direct.ed.gov/
- The National Student Loan Data System: http://www.nslds.ed.gov/
- The Federal Direct Loan Consolidation Program: http://www.loanconsolidation.ed.gov/
- Federal Student Loans: http://www.fafsa.gov/ and https://studentloans.gov
- College Savings Plans Network: http://www.collegesavings.org/
- For details on loans and other related information: www.finaid.com
- For information on states’ 529 plans: www.savingforcollege.com
- For Stafford Loans information: http://www.staffordloan.com/
Kobliner, Beth. “Get a Financial Life: Personal Finance in your Twenties and Thirties,” New York: Simon & Schuster, Inc., 2009.