Student Loans

By Mark Kantrowitz, Publisher of FinAid.org and FastWeb.com

There are two main types of student loans, federal and private.

You should always borrow federal first, as the federal loans are cheaper, more available and have better repayment terms. The interest rates on federal loans are fixed while the interest rates on private student loans are variable. Federal loans will generally cost you less money over the term of the loan. The unsubsidized Stafford loan and the PLUS loans do not depend on financial need, so you don't need to be poor to qualify for low-cost federal education loans. Private student loans are more expensive, and are mainly for filling the gap when you've exhausted your federal education loan limits or are ineligible for federal education loans.

Federal Loans

The federal education loans include the Perkins Loan, Stafford Loan, PLUS Loan and Consolidation Loan.

  • The Perkins loan is a low-interest loan available from some but not all colleges. The interest rate is 5% and the government pays the interest while you are in school and during a 9-month grace period after you graduate. Eligibility for the Perkins loan is based on financial need.
  • The Stafford loan comes in two versions, subsidized and unsubsidized. The government pays the interest on the subsidized loan while you are in school and during the 6-month grace period after graduation. You are responsible for the interest on the unsubsidized Stafford loan, but you can defer repaying it until after the end of the grace period by capitalizing it. This adds the interest to the loan balance, increasing the size of the loan. The interest rate on the unsubsidized Stafford loan is 6.8% for undergraduate and graduate students. The interest rate on the subsidized Stafford loan may be lower for undergraduate students. The subsidized Stafford loan is based on financial need. The unsubsidized Stafford loan does not depend on financial need, so even wealthy students can get it. The loan limits depend on several factors, discussed below.
  • The PLUS loan is available to parents of dependent undergraduate students (Parent PLUS loan) and to graduate and professional students (Grad PLUS loan). The interest rate is 7.9%. The PLUS loan does not depend on financial need, so even wealthy students can get it. The PLUS loan has an annual loan limit equal to the cost of attendance minus any other aid received. There is no cumulative loan limit. The PLUS loan requires the borrower to not have an adverse credit history, which is defined as a five-year look-back for certain derogatory elements of the credit history, such as bankruptcy, default, tax liens, wage garnishment, foreclosure and repossession, or a current delinquency of 90 or more days on any debt. If a dependent student's parent is denied a Parent PLUS loan, the student becomes eligible for the higher unsubsidized Stafford loan limits available to independent students.
  • The federal consolidation loan lets you combine several federal education loans into a single loan and provides access to alternate repayment plans. The interest rate is the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest 1/8th of a point, and capped at 8.25%.

The loan limits on the Stafford loan depend on year in school and dependency status.

There are a variety of criteria for independent student status, but the most common ones include: age 24 or older as of December 31 of the award year, married, having dependents other than a spouse, being a graduate or professional student, or being a veteran or active duty member of the Armed Forces. 

Independent students can borrow up to $9,500 in unsubsidized Stafford loans as a college freshman, $10,500 as a sophomore, $12,500 as a junior and $12,500 as a senior. There is also an cumulative borrowing limit of $57,500.

Dependent students can borrow up to $5,500 in unsubsidized Stafford loans as a college freshman, $6,500 as a sophomore, $7,500 as a junior and $7,500 as a senior. There is also an cumulative borrowing limit of $31,000. The subsidized Stafford loans are limited to $3,500 for college freshmen, $4,500 for sophomores, $5,500 for juniors and $5,500 for seniors, with an cumulative limit of $23,000. Any amounts received as a subsidized Stafford loan are subtracted from the corresponding unsubsidized Stafford loan limits. (Graduate and professional students can borrow up to $20,500 a year, no more than $8,500 of which can be subsidized.)

Starting July 1, 2010, all new federal education loans will be made through the Direct Loan program. To apply for these loans, contact the financial aid office at your college. After you tell the college how much you wish to borrow (up to the annual and cumulative loan limits), they will ask you to sign a Master Promissory Note (MPN). You will have to sign the MPN only once per college, as it is valid for all your federal education loans while you are enrolled.

Private Loans

Private student loans base eligibility and the interest rates on your credit score and the credit score of your cosigner. You have to have very good or excellent credit to qualify for a private student loan on your own. Most students will need a creditworthy cosigner in order to qualify. Even if you can qualify on your own, it can be worthwhile to apply with a cosigner if the cosigner has a better credit score, since this can reduce the interest rate on the loan.

Repayment

Federal education loans offer a variety of repayment plans. The standard repayment plan has a 10 year repayment term. Extended repayment increases the term to up to 30 years, depending on the amount you owe. For example, the repayment term can be 20 years if you owe at least $20,000, 25 years if you owe at least $40,000 and 30 years if you owe more than $60,000. Graduated repayment starts off with lower payments and increases them every two years.

Income-based repayment is available only for federal student loans, not Parent PLUS loans (or private student loans) and pegs the monthly payment to 15% of your discretionary income, with any remaining debt forgiven after 25 years. (The monthly payment under income-based repayment is 10% of discretionary income for new borrowers of new loans made on or after July 1, 2014, and the remaining debt is forgiven after 20 years.) Borrowers who repay their loans under the income-based repayment plan while working full-time in a public service job can have their remaining debt forgiven after only 10 years. Public service jobs include teachers, police, fire, public defenders, prosecutors, public and school librarians, military and anybody working for a tax exempt non-profit organization, not just people who work for the government.

Increasing the term of the loan will reduce the monthly payment but increase the cost of the loan. For example, increasing the term of an unsubsidized Stafford loan from 10 years to 20 years will cut the monthly loan payment by a third, but will more than double the interest paid over the life of the loan (a factor of 2.18 increase in total interest). If you can afford it, use as short a loan term as possible to help pay off the debt more quickly and save money.

A total of up to $2,500 a year in student loan interest can be deducted as an above-the-line exclusion from income on your federal income tax return. You can take this deduction even if you don’t itemize. The deduction includes both federal and private student loan interest.
Many colleges offer payment plans or tuition installment plans as an alternative to loans. These installment plans let you spread out the college costs into 9 or 12 equal monthly payments for a small up-front fee. This can be a convenient option if you can afford to pay the college bills, just not all at once.

Borrowing Smart

Here are several good tips for borrowing smart:

  • Minimize your debt.
    Live like a student while you are in school so you don't have to live like a student after you graduate. Every $100 you spend using student loan money now will cost you about $200 by the time you pay off your loans.
     
  • Avoid overborrowing.
     Don't borrow more for your entire education than your expected starting salary after you graduate. A student obtaining a degree in sociology or art history will earn less and should borrow less than a student graduating with a degree in computer science or nursing. Be realistic about your likely starting salary. Not every culinary arts graduate is going to turn into the next Emeril Lagasse, Rachel Ray, Wolfgang Puck or Bobby Flay.

    If you're borrowing more than $25,000 for an Associate's degree, $45,000 for a Bachelor's degree or $75,000 for a Master's degree, you may be borrowing too much. While income-based repayment provides a safety net in case your income falls short of your expectations, keep in mind that income-based repayment is not available for private student loans or Parent PLUS loans, so the ability to accommodate excessive borrowing is limited.

    If you will need to borrow excessively to pay for your education (say, more than $10,000 a year), you should consider enrolling at a less expensive college. Cumulative debt at graduation correlates strongly with the tuition rates and cost of attendance. The more expensive the school, the more debt you will accumulate by the time you graduate. You may have your heart set on your dream school, but if it means graduating with a luxury car payment worth of student loans, you will struggle to repay the debt. Your second choice college may be just as good but cost a lot less.
     
  • Pay at least the interest while you are in school, if you can.
    This avoids capitalization of the interest, which increases the loan balance. This will help you pay off the loan sooner and cut the total cost of the loan.

Mark Kantrowitz is an expert on paying for college. He is publisher of FinAid.org and Fastweb.com, the leading free web sites for information about student financial aid, student loans and scholarships.