More than 90% of student loans are federal loans, and with good reason: the federal student loan programs are broadly accessible and have a range of borrower protections. However, some borrowers choose private student loans either to borrow or to refinance. A smaller share of families use non-education loans such as home equity lines or 401k loans to pay for college. Let’s look at these options.
Private education loans are offered by many lenders and financial institutions. The terms vary by lender; a few key differentiators between federal and private loans are:
- Private student loans require a cosigner, unlike federal direct student loans, meaning that the cosigner is equally responsible for the loan.
- Interest rates may be variable instead of fixed and refinancing to lower interest rates may be offered.
- Repayment options may be quoted on different terms than federal loans, which are quoted on 10- or 30-year repayment schedules.
- Most offer in-school deferment with interest accruing.
- Some lenders may offer limited hardship provisions.
- Private loans cannot be refinanced into federal loans, although federal loans can be refinanced to private.
- New private loans issued after 2018 can be discharged in the event of the death of the student borrower.
Interest paid on any education loan– federal or private, parent or student– up to $2,500 is tax deductible for qualifying taxpayers. The deduction phases out at AGI of $70,000-$85,000 (single/head of household) or $140,000-$170,000 (married filing joint), and is an above-the-line deduction meaning you can claim it even if you don’t itemize. Only the named borrower can take the deduction, regardless of who’s making the payments. That means that parents paying off a direct student loan on behalf of the student don’t get the interest deduction, but the student would.
There are countless other types of loans available. One important consideration with any non-education loan is that you will need to begin making payments right away. This can ultimately result in more borrowing because as you direct cash flow towards loan payments, it’s not available for other expenses which leads to larger loans in subsequent years. Here are some of the most common types of loans families ask about:
Home equity lines: In some cases these can be a reasonable means of borrowing. Interest rates are generally cheaper than for parent PLUS loans and it’s possible to make interest-only payments in the initial years of the loan. HOWEVER:
- HELOCs have variable interest rates so you could end up with a much more expensive loan than anticipated
- HELOCs typically have a limited withdrawal period– usually 10 years. If you have an existing HELOC, you might not be able to continue withdrawing from it through the college years.
- DANGER WILL ROBINSON: The collateral for a HELOC is your home. That means if you default on your HELOC, the lender could foreclose on your house.
- Interest on the portion of your HELOC used for anything other than a home purchase or renovation is not tax deductible.
401(k) loans: No, no, NO!! This is a terrible idea:
- Repayment starts immediately and the maximum repayment term is 5 years.
- If you leave the company, the loan must be fully repaid within 60 days or is deemed a distribution and the balance is added to your taxable income for the year.
Personal loans: These are a lot like student loans but without the benefits of student loans: interest isn’t deductible and you can’t defer payments while in school.
Your starting point for borrowing should be the federal direct student loan, regardless of whether the parent or the student intends to be responsible for repayment. That’s because those loans have the lowest interest rates and most favorable repayment options, including hardship provisions. We usually recommend that families needing to borrow more than that start with the Parent PLUS loan even though there may be cheaper private loan options. That’s because you can always refinance a federal loan into a private loan, but you can’t go the other direction. Until you know how much you’re going to borrow total– over four years or longer with multiple students– it can be very beneficial to have the federal provisions available to you. At that point, you know what your total balance is and are in a better position to shop around for the best repayment option including refinancing.
Need another reason to start with federal loans? Only federal direct loans were suspended with no interest accruing during the pandemic and through the end of September, 2021. Private loans still required payments.
