In case you didn’t know it – college is expensive. Excruciatingly expensive. The average cost for an in-state public college is a little over $25,000 a year. Since most students no longer graduate in four years, but closer to six years in a public school, your overall price tag could range from $100,000 - $150,000.
If your child attends an out-of-state public college, the annual cost will be about $41,000 a year on average. Depending on whether they are lucky enough to graduate in four years or closer to the norm of six years, you’re looking at an overall price tag somewhere between $164,000 - $246,000. Ouch!
If your child wants to attend a private college, the average annual cost is around $55,000. However, there is a better chance your child will end up graduating in four years compared to the public-school options. But still, your overall price tag is likely to be around $220,000.
These high costs mean that many families will have to consider loans to help pay for college, whether you like it or not. But fortunately there are some good loan options that can help you cover your costs at reasonable terms and interest rates.
Let’s take a look at the seven types of loans that I review with parents who hire me to be their college planner. I’m going to review the basic terms, pros, and cons of the following types of loans:
1 and 2) Direct Loans (subsidized and unsubsidized)
3) Direct PLUS Loans
4) Private Loans
5) Home Equity Loans/Mortgage Loans
6) Retirement Plan Loans
7) Life Insurance Loans
Direct Loans (subsidized and unsubsidized)
Direct loans will be offered to the student if they completed the FAFSA application (refer to my previous blog: FAFSA Tips & Common Mistakes to Avoid) every school year. These are issued directly from the U.S. Department of Education to the student. So this will be a debt in the student’s name. But it requires no credit check and typically will be the lowest interest rate loan for which they can qualify.
I like to describe the Direct Loans in terms of tiers because there are two different ceiling limits. Your FAFSA calculated NEED will dictate whether the Direct loan is subsidized or unsubsidized. Refer to the chart below:
With the Subsidized Direct Loan, the Federal government subsidizes the loan by paying your interest while you’re enrolled in college at least half-time. And you don’t have to start making payments until six months after graduation or fall below half-time enrollment.
Whereas the Unsubsidized Direct Loan’s interest is accumulating while you’re enrolled in college. Ideally you should make the monthly interest payments as they accrue. You do have an option to defer the payments until you graduate; however, the deferred interest will be capitalized, leaving you to pay the extra debt of interest on top of interest.
Since these loans must be re-applied to every year, the interest rate on the Direct Loans (subsidized or unsubsidized) is reset every year by the Federal government. But whatever you borrowed in a particular year, that particular rate will remain the same throughout the life of the loan. In the 2021-2022 academic year, the interest rate was only 3.734%. It hasn’t been announced yet, but many believe the 2022-2023 academic year will see the interest rate jump to 5.02%. It is supposed to be 2.05 percentage points above the 10-year Treasury yield. The official interest rate should be officially announced later this month or in early June.
Pros to the Direct loans
+ Subsidized: the Federal government pays your interest while you’re enrolled at least half time and up to six months after you graduate
+ Unsubsidized: like the subsidized version, repayment of principal begins six months after you graduate
+ No credit check on the student
+ Interest rates are typically lower than other loan options available to a student
+ repayment window is 10 years, but you might be able to extend it if your financial circumstances warrant it
+ there is a loan forgiveness program in place for those employed by a government or not-for-profit organizations, or those who become teachers
Cons to the Direct loans
- - Unsubsidized: interest accrues while enrolled in college
- - Relatively low borrowing limits
Parent Loans for Undergraduate Students (PLUS)
Somewhat similar to the Direct loans offered to a student after completing a FAFSA, parents will be offered a Parent PLUS loan by the U.S. Department of Education. Parents will be allowed to borrow enough to cover the overall estimated cost of attendance (including incidentals built into the school’s budget, but not an actual charge from the school) minus any financial aid awards and loans taken by the student.
PLUS Loans aren’t based on financial need, so parents can qualify by simply having decent or marginal credit. If you placed a freeze on your credit file, you’ll need to lift the freeze at each credit bureau before you apply. If you have poor credit, you might still qualify if you meet additional requirements. Most parents do. Things that make it harder to qualify for a PLUS loan are 1) accounts with a total outstanding balance greater than $2,085 more than 90 days delinquent, 2) a default within five years, 3) a bankruptcy within five years, 3) foreclosure within five years, 4) wage garnishment within five years, or 5) a tax lien within five years.
Parent PLUS Loan interest rates are always 2.55% higher than the rates for student Direct Loans. For loans taken out during the 2021-22 school year, the parent PLUS Loan rate was 6.284%. For the 2022-23 academic year many believe the PLUS loan rate will be about 7.57%. The official rate will be announced later this month or early June.
PLUS loans work similarly to the Unsubsidized Direct loans for students. Interest rates will be updated every year, but whatever you borrowed in a particular year, that particular rate will remain the same throughout the life of the loan. Parent PLUS loans begin their repayment 60 days after final disbursement for the academic year. However, you can request a deferment up to six months after the student graduates (or falls below half-time enrollment). If you do opt to defer, I still recommend paying the interest payments while the student is enrolled. Otherwise, you are capitalizing the debt.
Pros to the PLUS loans
+ parents only need marginally good credit
+ parents can borrow up to the total cost of attendance minus other financial aid
+ parents can defer payments while the student is enrolled up to six months after graduation
+ repayment window is 10 years, but might be able to extend it if your financial circumstances warrant it
Cons to the PLUS loans
- - parents are borrowing the money in their name, therefore they are responsible for paying it back
- - interest is accruing while the student is enrolled
- - interest on the PLUS loan will always be 2.55% higher than Direct loans
Typically private loans for college will be made in the student’s name; however, they are credit-based. Therefore, parents or grandparents usually are needed to co-sign these loans in order to be approved. Therefore the loan’s terms will be based on the parents’ ability to repay the loan.
The final terms of a loan will range from decent to awful, so be careful. Some lenders may even let the parent fall off as a co-borrower after a certain number of payments are made by the student. However, that feature may cost more in terms of the interest rate. Generally every university will provide a list of preferred lenders that they work with. In exchange, those lenders tend to provide pretty favorable terms. However, if the borrower (or co-borrower) has really good credit, they may be able to find something better outside of the university’s list. A quick internet search will provide you many companies to consider.
Pros to Private loans
+ like a PLUS loan, you can borrow up to the total cost of attendance minus other financial aid
+ if you have really good credit, you may get a better rate than the PLUS loan
Cons to Private loans
- - if a parent/grandparent co-signs as a borrower, they are still on the hook to repay the loan if the student is unable
- - if your credit isn’t good, the interest rate may be higher than other loan options
- - generally are not mentioned in the talks about student loan forgiveness
Home Equity Loans/Mortgage Loans
If you own a home and have equity, a home equity loan or mortgage refinance could provide additional funds for college at a lower interest rate than you might get from a Parent PLUS Loan or other private loans. The repayment period tends to be longer, which could mean lower monthly payments, which could be easier on your cash flow. However, if you take a home equity loan or refinance your mortgage, you are putting your home at risk in the event you’re unable to pay.
Pros to Home Equity Loans/Mortgage Loans
+ if you have good credit, you potentially could get a better interest rate than a private loan or a PLUS loan
+ longer repayment periods generally mean a smaller monthly payment
Cons to Home Equity Loans/Mortgage Loans
- - you risk losing your home if you’re unable to pay off the loan or refinanced mortgage
- - if your credit isn’t good, the interest rate may be higher than a PLUS loan
Retirement Plan Loans
Many retirement plans allow you to borrow up to 50% of your retirement account balance up to a limit of $50,000. Typically these loans only offer a five-year repayment plan. Being the shortest repayment window means this type of loan probably the highest monthly payment. Worst of all, you are also losing any potential investment growth on the money you pulled out. Sometimes the interest you pay goes back to your plan provider, not your own account. So you are actually paying interest on your own money to someone else. Therefore, this option can end up being a triple whammy against you.
Pros to Retirement Plan Loans
+ you may be able to borrow up to $50,000 towards college costs
+ if you’re a business owner, you may have additional creative opportunities because you’re in charge of the business’ retirement plan. Consult your financial advisor to learn more about your options.
Cons to Retirement Plan Loans
- - you lose the potential investment growth on any money you pulled out
- - you are paying someone else interest to access your own money
- - typically there is only a five-year repayment window
Life Insurance Loans
If you set up a permanent life insurance policy, such as a whole life or Indexed Universal life, a portion of your premium goes towards the death benefit and another portion is put into a cash-value account. If you have built up the cash value in your life insurance (similar to how you build up the cash value of your 401(k) or other retirement plan), you can take out a policy loan against the cash value. Interest rates on life insurance policies tend to vary between 5-8%. Depending on the terms of your policy, the rate may be fixed or variable.
Life insurance loans have numerous advantages to the other loans listed. For one, you don’t have to pay back the loan at any given time. You get to choose when and how much you want to pay back, if any at all. When you die, any unpaid loan amount plus accumulated interest will be paid by your death benefit before being dispersed to the beneficiary. Also, when you take a loan from your permanent life insurance policy, the amount is not reducing the potential investment growth. So if you have $200,000 in cash value and take a $40,000 policy loan, your cash value is not reduced to $160,000. Rather, it still grows at the $200,000 amount. This is because the loan is with the insurance company and your cash value is used as collateral.
Another advantage is any money you take as a policy loan from your life insurance policy is not taxed, nor does it impact the financial aid calculations.
Pros to Life Insurance Loans
+ flexible use – loans can be used for any purpose, not just limited to college
+ flexible repayment – loans can be repaid at whatever pace and amount you choose. Upon death, any unpaid loan amount will be paid by your death benefit.
Cons to Life Insurance Loans
- - requires you to plan early because the fees of life insurance are front loaded, it can take about 10 years for the cash value accumulation to be competitive to other options
- - if you have good credit, you may be able to obtain a different loan with a lower interest rate
Hopefully this overview has been helpful. As you can see, you have quite a few loan options when it comes to helping pay for college. If you have any questions, feel free to reach out to MAC’s in-house college planner, J.P. Schmidt.
If you haven’t yet put together a holistic plan on how to pay college, one that involves the options for saving ahead and how to maximize financial aid (free money), please reach out to MAC Insurance & Financial Services right away.