Families who borrow for college have a lot of choices: federal or private student loans, personal loans, home equity loans, 401k loans… How do you decide? Let’s look at pros and cons of some of these, starting with the federal loan programs.
Federal direct loans– whether student or parent loans– have a number of benefits:
- Fixed interest rates
- Income-driven repayment programs
- In-school deferral (in many cases, interest accrues during the school years)
- Hardship provisions
- Extended repayment options
- Public Service Loan Forgiveness (PSLF) for eligible borrowers including parents (via Direct Consolidation loans)
- Payments on all federal direct education loans are suspended, with no interest accruing, until Sept. 30, 2021.
The Direct Student Loan has the lowest interest rate among all the loan programs, and as a general rule it should be every family’s first choice for borrowing. Even if the parents intend to repay the loan, taking out the student loan rather than the parent PLUS loan will save thousands of dollars in interest over the repayment term.
The direct student loan has a big drawback: annual limits on borrowing. First-year students can borrow a maximum of $5,500; the maximum over four years is $27,000.
Parent PLUS Loans are federal education loans that parents can take out to finance their children’s education. Parents can borrow more than students– up to the student’s full Cost of Attendance annually. Parent PLUS loans are less favorable than direct student loans:
- Interest rates are always 2.55% higher than the rates on direct student loans. That means that you would pay about $1,000 more in interest during repayment if you took out a $5,500 parent PLUS loan instead of a direct student loan. The interest rate for the 2021-22 school year is 6.284%, which is higher than just about any other type of loan.
- Parent PLUS loans have an origination fee of 4.228%. So every $10,000 you borrow costs $422.80 in origination fees. This fee is simply added to the loan balance.
- Parent PLUS loans allow for in-school payment deferral but no interest subsidy is offered.
- The only option to transfer a parent PLUS loan to the student post-graduation is for the student to qualify for a different loan, take out that loan and use it to repay the parent PLUS loan.
- While any student can take out a Direct Student loan, parent PLUS loans can be denied on the basis of credit. (Students whose parents are denied parent PLUS loans can take out larger Direct Student loans, however.)
Parent PLUS loans, like all federal direct education loans, have a unique benefit when compared with other loans: they are non-recourse, meaning that if the borrower dies or becomes disabled, the loan is discharged with no one else needing to assume liability for it. That can make for some instances where parent PLUS loans are a good option, such as an older parent. For example, a 70-year-old parent who might have a 15 year life expectancy following the student’s college graduation could borrow PLUS loans, then go into the 30-year repayment plan and have the balance forgiven upon their death.
In addition, parents can be eligible for Public Service Loan Forgiveness just as students can. So a parent who is a public school teacher and has a long enough career horizon in front of them to make enough qualifying payments to be eligible for forgiveness. (To be eligible for PSLF, parent PLUS loans need to be consolidated into Direct Consolidation loans.)
Generally the federal student loan programs are a family’s best starting point for borrowing, for a few reasons:
- Student loans don’t require a co-signer
- All federal direct education loans are eligible for hardship relief programs and can be enrolled in income-driven repayment programs and public service loan forgiveness. Currently this includes payment suspension with no interest accruing through Sept. 30, 2021.
- While federal loans can be refinanced into private loans, private loans cannot be refinanced into federal loans. Thus you can always change from a federal loan to a private one should that be to your benefit, but once you have a private loan, it will stay a private loan.
One downside of federal loans, especially parent and grad PLUS loans: you cannot refinance to a lower interest rate in the federal loan program. That means that borrowers who took out loans with high interest rates– some as high as 7% or 8%– are stuck with those interest rates if they stick with federal loans. For a borrower enrolled in PSLF, the interest rate doesn’t really matter since all payments are income-based, not based on a traditional amortization schedule of principal and interest, and any remaining balance is forgiven tax-free after 120 qualifying payments. But for regular borrowers, paying a 3% or more higher interest rate can cost a fortune over the lifetime of a loan.
More to come on private student loans and other forms of borrowing!