Student loans have become a polarizing topic in America today. There have been calls for Congress to enact policies that forgive student loan debt. And in August, President Joe Biden announced that the Department of Education will discharge more than $5.8 billion in federal student loans for borrowers with disabilities. Some cheer this as a possible first step toward broader debt forgiveness, and others worry that the U.S. debt is already unnervingly high and student loan forgiveness will only make it worse. It’s a nuanced and complex conversation that I won’t attempt to address here, but the bottom line is college is a significant expense for families, and most students need some help paying for it.
Having just fully paid off my own student loans, I sympathize with all the voices in this conversation. It took me almost 20 years to repay this loan for a degree in audio engineering, and as a wealth manager today, I often wonder if I made the right choice to take on the debt at the time.
As financial planners, we focus on proactively seeking out the best opportunities for our clients to fund the education needs of the important people in their lives. We set up and fund 529 college savings plans early and provide a map to college admissions that focuses on obtaining grants or other merit-based financial aid. But even with thoughtful planning, there may be a shortfall when it comes time to enroll.
First exhaust all other options
Before considering student loans, we encourage you first to check out the following opportunities to pay for college:
- On September 26, the Department of Education launched a Federal Student Aid Estimator, a free tool to calculate how much aid a student may be eligible for.
- File the FAFSA (Free Application for Federal Student Aid). Even if you know you won’t qualify for need-based aid, filing a FAFSA is recommended for two reasons:
- Anyone who applies is entitled to a loan
- Applying gives the student access to merit-based scholarships
- Students who don’t qualify for federal financial aid should work with their college counselor to explore scholarship opportunities.
- Grandparents, other family members or family friends may want to contribute to the student’s education by making direct payments to the institution. Providing gifts directly to the student is also an option, but large gifts can affect financial aid or have tax implications, so it’s best to consult your financial advisor first.
Types of loans
If a funding gap remains after exhausting these options, a student loan can provide meaningful support and allow the student to focus full-time on academics instead of working to pay bills. When considering a student loan, it’s important that the borrower understands the financial responsibility they’re taking on. And you may want the student to have some “skin in the game” to share the cost burden. If you’re not comfortable having this conversation with the student, we recommend setting up a call with your financial advisor prior to moving forward.
There are primarily two providers of student loans: the federal government or private lenders such as banks, credit unions or online lenders. By filing the FAFSA form, the federal government will assess how much federal aid — grants and scholarships, work study programs, and student loans — the student qualifies for. We generally recommend exhausting federal loans first for the following reasons:
- Private loan qualification is stricter. Whereas federal loans are need-based, private loans are credit-based. The student will need to have a good credit score and adequate income to qualify for the loan, otherwise they’ll need a co-signor. Most federal loans can be obtained without a co-signor.
- Interest rates are typically lower on federal loans. This is easy — the lower the rate, the less money the borrower will ultimately repay over the life of the loan. However, some federal loans come with origination fees, so take this into consideration when comparing rates against private loan products.
- Subsidized loans could be available. If the student is an undergraduate, they could qualify for a subsidized loan. Interest on a subsidized loan balance does not accrue until the student graduates (grace periods and deferments can also apply). Private loans (and federal loans for post-graduate study) are unsubsidized, so the student will begin accruing interest on the balance once the loan is in place.
- Repayment flexibility and forgiveness. Federal loans offer more flexibility when it comes time to repay the loan. Students have a range of options from multi-year forbearance to income-based repayment schedules. The government also offers forgiveness programs to help reduce or cancel loans for qualifying graduates. These programs typically do not apply to private loans.
While we prefer federal loans, the government places an annual limit on how much a student can borrow from the program. Therefore, some students will also need to obtain a private loan to bridge the shortfall.
Important questions to answer before selecting a private loan
As you evaluate your options, we believe the following considerations are most important when selecting the right loan. Each borrower and lender is unique, therefore the prioritization of the items below will need to be determined as you consider your options.
- Prepayment penalties: Are there any penalties or fees associated with the loan’s prepayment?
- Co-signer release clause/criteria: If you’re considering co-signing, does the loan have a co-signer release clause? If so, what are the conditions the borrower must meet to release the co-signer, and do they make sense for both of you?
- Relief options: In the event of a repayment difficulty, does the lender offer forbearance, deferment or income-based repayment? If so, are the conditions for obtaining the relief reasonable and attainable?
- Payment schedules: When does repayment begin? Some loans require interest-only payments while enrolled and others don’t start until the borrower is employed. Know what the grace period is after graduating and the length off the repayment terms.
- Fees: Will you be charged fees? Many private lenders have scrapped origination or application fees, essentially rolling them into the interest rate. Read through the fee schedules to learn what the extra costs are and how to avoid them.
- Interest rates: Do you understand the pros and cons of fixed and variable rates? Fixed interest rates generally have a higher floor than variable rate products, but you don’t assume interest rate risk. Variable rates are usually stated as LIBOR + a margin and are vulnerable to higher monthly payments if the governing benchmark rate creeps up over time.
- Credit report inquiry impact: Are lenders making hard or soft credit inquiries? Lenders will look at both the student’s and the parent’s credit reports if the parent co-signs. Limit the impact to your credit score by doing your rate shopping for one type of loan (fixed or variable student loan) during a two-week window if you need to make hard inquiries while shopping. Your FICO calculation will take all credit inquiries of a similar nature and count them as only one inquiry if you do it this way, limiting the impact to your credit score.
- Data policies: Will your personal information remain private? While some platforms may offer to shop multiple rates for you using only a soft inquiry on your credit report and a straightforward application, they may not have favorable personal data policies (i.e, they could sell your information to third parties or communicate that you are shopping for a loan to undesired providers). Be sure to review data use policies before providing any lender or platform your personal information.
In addition to the guidance above, one additional factor is worth prioritizing: time. Enrolling your student in college can be an emotional and time-consuming endeavor. We recommend that you start as early as you can by speaking with a financial advisor, a college counselor, and other parents in your network who have walked this path before. The last thing you need is a looming deadline driving your loan decisions. An early FAFSA submission coupled with the guidelines above can sidestep a lot of confusion and stress, freeing up quality time to spend with your star student.