Hi everyone! Welcome back to Melissa Making Cents!
I’ve been talking a lot recently about how comprehensive college planning can save you money on education in the long-run. But even if you plan in advance, it’s likely that you will still need to acquire some additional funds in order to cover the tuition bill. That’s why today, I’m going to do a deep dive into the dreaded L-word...loans.
Funding college is hard enough, but weeding through the different types of loans is (in my humble opinion!) the most challenging part of the college application process. Federal loans, private loans, interest rates, subsidized vs unsubsidized...where do we even begin?! And what should we know in advance to get our loans paid off? In this post, I’ll provide an overview of the major types of student loans. Then I’ll do a closer comparison of federal loans and private loans, as well as the pros and cons of each. Let’s get started!
Federal Loans Are the Most Commonly Used Student Loans
Most student loan debt--a whopping 92%--consists of federal loans. As of 2019, there were 43 million federal student loan borrowers, holding an outstanding $1.4 trillion in debt. In order to be eligible for a federal loan, you will need to fill out the Free Application for Federal Student Aid (FAFSA). However, not all federal loans are created equal. Below are some of the different types of federal loans. For those borrowers who may have already started college, I’ve also included a few programs that were recently discontinued, as well as recommendations around consolidating multiple types of loans.
What is a Federal Direct Stafford Loan
Both undergraduate and graduate students are eligible for Stafford Loans, which are also known as the federal Direct Loan program. Stafford loans are funded by the federal government, specifically the US Department of Education, so they are known for having generally favorable terms for borrowers. There are two types of Stafford Loans: subsidized and unsubsidized. Here are the major differences between them.
Direct Subsidized Loans are Available For Need Based Students
Subsidized loans are allocated for students with demonstrated financial need. In fact, most direct subsidized loans are distributed to families with an annual income less than $50,000.
There are two major advantages of direct subsidized loans. The first is that the student will not need to make any payments until after graduation. The second is that interest will not accrue while the student is in school. That’s four years of saving on interest, so students will be able to start paying off the principal on the loan faster. For the 2019-2020 school year, the interest rate was 4.53% for undergraduates and 6.08% for graduate students. New interest rates are set by the federal government each July 1st for the upcoming school year.
However, there are limits on subsidized loans. Freshmen can borrow up to $3,500 in subsidized loans. Sophomores are eligible for $4,500, while juniors and seniors can take out up to $5,500 in subsidized loans. If these amounts do not cover the cost of education, students will need to resort to additional loan options.
Direct Unsubsidized Loans are Available to Everyone
Unsubsidized loans are available for all undergraduate and graduate students, regardless of financial need. While subsidized loans do not accrue interest until after graduation, unsubsidized loans accrue interest while the student is still in school. The good news is that borrowers don’t need to make payments right away -- they are usually deferred until after graduation -- but those few extra years of interest can add up! As with the subsidized loan, the interest rate was 4.53% for undergraduates and 6.08% for graduate students for the 2019-2020 school year.
The limit for unsubsidized loans is a little higher than for subsidized loans. The range for undergraduates is from $5,500 to $12,500 per year. This number depends on the student’s year in school, if they are claimed as a dependent, and if the parents are eligible for PLUS loans (more on those in a minute!). Graduate students can borrow up to $20,500 annually in Stafford loans, or $40,500 per year for medical students.
Parent PLUS Loans Are Available For Parents
Parent PLUS loans are another type of loan funded by the federal government. These are exclusively for biological or adoptive parents of dependent undergraduate students. Unlike Stafford loans, there are no limits to the amount that parents can borrow under the PLUS loan program (up to the school’s cost of attendance). PLUS loans can also be used for any education costs that other financial aid won’t cover.
One of the benefits of PLUS loans is that they don’t require minimum credit scores or debt-to-income ratios. However, borrowers need to have strong credit histories. Otherwise, they will require a co-signer. The current fixed interest rate for the Parent PLUS loan is 7.08%, and there is an additional loan fee of 4.236% deducted from each disbursement. Interest accrues while the student is in school.
Finally, because this is the Parent PLUS program, the parent remains responsible for paying off the entirety of the loan. The loan cannot be transferred to the student. However, payment can be deferred until six months after the student’s graduation. Good news.. Parent PLUS loan borrowers can take advantage of the Public Service Loan Forgiveness programs!
Graduate PLUS Loans Are Available to Graduate Students
While Parent PLUS loans are specifically for parents, Graduates PLUS loans are for...you guessed it...graduate students. The students must take out the loan themselves and cannot transfer the loan to a parent. As with the Parent PLUS loan, a good credit history is important (and an adverse credit history means that the borrower will need a co-signer).
Graduate PLUS loans also have a fixed interest rate, currently at 7.08%, and a loan fee of 4.236%. This loan limit is up to the school’s cost of attendance, and students do not need to start paying off the loan until six months after graduation. However, interest will continue to build while the student is in school.
Perkins Loans Are Loans That Provided Benefits to Public Service Employees (Discontinued)
The Perkins Loan program ended in 2018, but there are still plenty of students in school (or who recently graduated) with this type of financial aid. Approximately 1700 schools in the U.S. took part in the Perkins loan program. Undergraduates were permitted to borrow up to $5,500 per year in Perkins loans, while graduate students could borrow up to $8,000 per year.
Perkins loans were also subsidized (meaning no interest accrued while the student was in school), had a fixed interest rate of 5%, and offered a nine-month grace period before repayment. However, Perkins loans were only available for students with significant financial need. In addition, borrowers who currently hold Perkins loans and work in public service or teaching may be eligible for Perkins loan forgiveness.
Federal Family Education Loans – FFEL (Discontinued)
The Federal Family Education (FFEL) loans were discontinued in 2010. FFEL was the predecessor to the Direct Loan program. The main difference between FFEL loans and the Direct Loan program is that FFEL loans are categorized as “federally-guaranteed” rather than “federally held.” “Federally-guaranteed” means that although FFEL loans are backed up by the federal government, the money itself comes from private banks and other financial institutions. Most of the time, this distinction doesn’t matter very much, but it is important when it comes to eligibility for economic relief programs such as the recent CARES Act.
Direct Consolidation Loans
You may have noticed by now that each of these types of loans has a limit, so students are often taking out multiple loans to cover the cost of school. Think about this: if a student takes out a loan with a different servicer every semester, they could have eight different payments due when it’s time to start paying!
Instead of worrying about multiple loans, another option is to instead apply for a Direct Consolidation Loan. This streamlines the process by combining all of the federal loans into one, so that borrowers only have to worry about one payment to one servicer per month. Only federal loans are eligible for the Direct Consolidation Loan.
You can only consolidate student loans once, and the Direct Consolidation loan has a fixed interest rate. There are a few pros and cons to this. Consolidation might mean that your monthly payments become lower, if some of your individual loans had high interest rates or variable rates. However, you may need more time to pay off the loan or end up paying more interest over the long run.
It is worth noting that consolidating older Perkins and FFEL loans in the Direct Consolidation loan is an option, but it may or may not be a good idea depending on your circumstances. For example, consolidating your Perkins or FFEL loan with your Stafford loans could make you eligible for the six-month forbearance period through the CARES Act for coronavirus relief. However, consolidating a Perkins loan could also mean losing out on the nine-month forbearance period after graduation. If you are planning to work in public service or as a public school teacher, you could also lose out on the Perkins loan forgiveness program. By contrast, borrowers with FFEL loans who consolidate may become eligible for the Public Service Loan Forgiveness program. I always recommend checking in with a financial advisor to crunch some numbers and determine the best path for you.
Private student loans
Okay, let’s switch gears a bit to talk about private loans. Private education loans are available for individuals who still need more funds to cover the cost of education after maxing out federal loans. Private loans are available from private banks, credit unions, and other financial institutions. About 8% of outstanding student debt is held in private loans.
So what determines eligibility for a private loan, and how much can be borrowed? The answer is: it depends! Credit history plays a role in eligibility and what the interest rate is for private loans. Private loan borrowers usually need a credit score of 640 or higher. Borrowers with a limited credit history (so...most undergraduates) will likely need a co-signer to qualify. Students or parents can take out private loans, and the interest rates and repayment terms will vary by lender and your financial situation.
Comparing Federal and Private Loans
So let’s take a step back. What are some of the key differences between federal loans (all types) and private loans? It mostly comes down to eligibility, interest rates, and repayment terms.
Let’s start with eligibility. While federal loans are usually only available for U.S. citizens, private loans can also be available for international students. Private loans are also available for borrowers regardless of financial need, whereas some federal loans are only available for borrowers with demonstrated economic hardship. In addition, undergraduates who apply for federal loans will not have to undergo a credit check, whereas private loans usually require a credit check (and often a co-signer) to determine eligibility.
While most of the federal loans offer a fixed interest rate, private student loans can have fixed or variable rates. The interest rates for private loans tend to be higher than federal loans. Some of the major disadvantages of private loans are that they will accrue interest while the student is still in school, and some require payments before graduation, too.
In addition, private loans have fewer options for deferment and forbearance compared to federal loans. Federal loans are much more flexible in terms of repayment options and loan forgiveness programs (especially for borrowers who pursue careers in public service). During the coronavirus outbreak, several federal loans are also eligible for special forbearance periods through the CARES Act, while private loans are not.
Ultimately, the best student loan options for you will depend on your family’s circumstances. I generally recommend exhausting all other avenues of financial aid (scholarships, federal loans, etc.) before turning to private student loans because interest rates are usually higher and the repayment terms are not as favorable. I’m also a huge advocate of comprehensive college planning, which can help you defray the cost of college to begin with so you will not have to rely as much on student loans. As a Certified Financial Planner, I’ve helped families all over the Dallas area save on college costs and get the financial aid package that’s right for them. Whether you’re just starting to look at colleges or finalizing your application for financial aid, please call or email to schedule an appointment with me.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox
CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor in Dallas Texas.