About 1/3 of students and 1/5 of parents borrow to pay for college, with borrowed money covering about 21% of the total cost of college, according to Sallie Mae’s How America Pays for College. The report also showed that while federal student loans were the most common form of borrowing, about 10% of students used private loans as well. That’s too bad, because the federal loan programs have some protections that can be really valuable during school and for recent graduates entering the workforce.
Federal loans come in four types:
- Direct subsidized loans are loans for undergraduates. The subsidy refers to the treatment of interest during the school years: no interest accrues on the loan while the student remains enrolled at least half time, for the six month grace period following graduation and during deferment periods. Subsidized loans are awarded on the basis of need. These loans have an annual cap of $3,500 for the first year, $4,500 for the second year, and $5,500 for the third year and beyond.
- Direct unsubsidized loans are also for undergraduates; these do not receive the interest subsidy so interest begins to accrue as soon as the loan is disbursed. Loan limits are $5,500 for the first year, $6,500 for the second year, and $7,500 for subsequent years. (Students receiving subsidized loans can borrow additional unsubsidized funds up to the aggregate annual limit, meaning a first year student with $3,500 in subsidized loans could borrow an additional $2,000 in unsubsidized loans.) Independent students or those whose parents do not qualify for PLUS loans can borrow an additional $4,000 in each of the first two years and $5,000 in subsequent years.
- Direct PLUS loans are for parents or graduate students. For the 2020-2021 school year graduate students can borrow up to $20,500. Parents can borrow up to their student’s full cost of attendance minus any financial aid.
- Direct consolidation loans are loans that combine multiple federal loans into a single loan. These are often used by graduates needing to refinance older federal loans into newer federal loan types in order to qualify for income-driven repayment plans.
Direct subsidized and unsubsidized loans have the best rates: 2.75% for the 2020-2021 school year, compared with 5.3% for parent PLUS loans. So even if parents are doing all the borrowing, they should start with the direct student loan and only take out PLUS loans for amounts in excess of the student loan limits.
The federal loan programs have numerous benefits:
- Fixed interest rates for the life of the loan.
- No co-signer or credit approval required for student loans.
- Deferral while in school. This is automatic for student loans and optional for parent loans.
- Options for deferring payments in times of financial hardship. (Note that interest continues to accrue.)
- Eligibility for income-driven repayment programs and, for those in qualifying jobs, public service loan forgiveness.
- Currently, all federal student loans are in deferment with no interest accruing, thanks to the CARES Act.
In addition, while federal loans can be refinanced into private loans, private loans cannot be refinanced to federal loans. Some graduates who are established in their careers and less reliant on the federal loan protections may find that they can refinance federal loans to private loans to get lower interest rates. However, the reverse is never true: private loans will remain private loans until they are paid off.
Federal loans are disbursed through the school, so students (or parents) wanting to borrow will need to complete the school’s requirements in order to do so. These may range from simply selecting a loan as part of your payment to submitting forms in advance to the financial aid office.
And before you borrow, remember that while student loans may be discharged in bankruptcy, it’s extremely difficult to actually get them discharged. Student loan borrowers need to go through an additional lawsuit– an adversary proceeding– to demonstrate that the loans present an “undue hardship.” Typically this is based on the Brunner test, which has three components:
- Can you pay your bills– including student loan payments– right now and still maintain a minimal standard of living? One challenge to proving this is that being able to pay an attorney to represent you is often seen as disproving this.
- Will you earn enough money to make payments on your loans? This typically means that you are already at or near the top of the pay scale for your type of work, that you are disabled or received a poor-quality education.
- Have you made good faith efforts to pay your loans before bankruptcy? This does not require the debtor to be current on their loan payments; rather, actions such as attempting to negotiate a payment plan or taking a second job to increase earnings can be used to demonstrate this.
And of course, all three components have elements of subjectivity, meaning actual dismissal depends at least to some degree on the judge and jurisdiction.
