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Fight the fear of financing: Understanding student loans

Private and federal student loans

For many, figuring out how to finance a college education is a task fraught with fear and anxiety. But the fact is, a majority of bachelor's degree students borrow money to pay for their educations -- and the amount they borrow is growing. According to a report by the Project on Student Debt, the average loan debt for graduating seniors grew from $18,650 in 2004 to $25,250 by 2010.

"It's essential that parents and students understand about college planning, particularly the financial aspects -- not only the short term goal of how to pay for the student's education, but the equally important longer term goals of budgeting and debt management," says Vince Sampson, president of the Education Finance Council, an association for nonprofit and state-based student loan providers. Understanding more about education loans can help you make an informed decision about whether to borrow and how much.

Who are the lenders?

Federal loans: The lender is the federal government through the Federal Direct Loan program. Loans include:

  • Subsidized loans (interest paid by the government while you are in school)
  • Unsubsidized loans
  • PLUS loans for parents of dependent students and graduate and professional students

Private loans: The lenders include banks, credit unions, finance companies, trade associations and state higher education programs.

Who is eligible?

Federal loans: U.S. citizens and eligible noncitizens.

Private loans: U.S. citizens and eligible noncitizens. Some private lenders may offer loans to foreign nationals attending U.S. schools and working toward a degree. Some non-standard education loans may also be available.

How do I apply?

Federal loans: File the Free Application for Federal Student Aid, or FAFSA, online. PLUS Loan applicants file a separate application with the school. Eligibility and loan amounts are determined by the school. PLUS borrowers with adverse credit may require a cosigner.

Private loans: Contact the lender directly to apply. Private lenders use credit scores to determine loan eligibility and may require a cosigner for those with adverse credit. Loan amounts are determined by the lender; some lenders require schools to certify the cost of attending the school.

How much can I borrow?

According to a report by the Project on Student Debt, the average debt per student for 2010 college graduates was $25,250. Experts recommend you borrow the absolute minimum you need to pay for your education. Loans can be used for tuition and fees, books and supplies, room and board, and other educationally-related expenses as defined by the school.

Federal loans:

  • Dependent undergraduate students can borrow $31,000 total; only $23,000 can be subsidized
  • Independent undergraduate students; $57,500 total/$23,000 subsidized
  • Graduate students; $138,500 total/$65,500 subsidized (totals include amounts borrowed as an undergraduate)

Each year, parents and graduate and professional students can borrow Federal PLUS Loans in an amount equal to the cost of attending the school minus any financial aid received by the student.

Private loans:

Some lenders have minimum and maximum loan amounts. The annual loan amount is usually the cost of attending the school minus any other financial aid the student is receiving. Private loan amounts that exceed the cost of education at the school are considered additional resources and could reduce other need-based aid.

What about fees?

Federal loans:

  • Subsidized/unsubsidized loans: 1 percent origination fee for each loan
  • Parent and graduate/professional PLUS loans: 4 percent origination fee; graduate/professional students may be eligible for a 1.5 percent rebate

Private loans:

Origination fees run from 0 to 5 percent; the fee can vary based on credit score, amount of the loan, and other factors determined by the lender.

What are the interest rates?

Federal loans:

  • Undergraduate/graduate subsidized and unsubsidized: 6.8 percent fixed (Note: until June 30, 2012, undergraduate subsidized interest rate is 3.4 percent)
  • PLUS loans: 7.9 percent fixed

Private loans:

Both fixed and variable interest rates are available from 2.8 percent to over 13 percent, depending on borrower circumstances and the lender. The interest rate offered can depend on the loan amount, repayment option chosen, borrower or cosigner credit score, and other lender-defined factors.

What other factors should I consider?

Informed comparison shopping is a good idea, even for education loans. Compare the following factors for all loans and all lenders:

  • Repayment options: Federal loans have a variety of repayment options including income-based with repayment periods up to 30 years; private lenders may offer more than one option.
  • Deferment, forbearance, cancellation, and consolidation: The federal loan program offers all of these options; private lenders may or may not.
  • Timing: In many cases, a private loan can take less time to process than a federal loan.
  • Special perks:
    • Federal loan -- no special deals
    • Private lenders offer deals such as discounted interest rates for automatic loan payments, making a specified number of on-time loan payments, having other loans with the lender, or just for graduating.

Which loan is the best choice?

The Columbia University Student Financial Services website notes that graduate students who are deciding between federal and private loans might prefer federal loans if they like the security of a fixed interest rate, have less than excellent credit, anticipate future need for deferment and forbearance options, or require 10 or more years to repay their loans.

Students who have top credit, who don't anticipate using deferment or forbearance options, and who plan to borrow for only a short time might prefer private loans as long as they're comfortable with variable interest rates, which are currently lower than fixed rates.

To borrow or not to borrow?

Before you head down the student loan path, Beth Walker, financial planner at Strategic Wealth Associates and "head coach" at College Funding Coaches, offers some sage advice, "Students need to make realistic assessments of their salary potential and take out loans accordingly." She recommends that post graduation monthly loan payments shouldn't exceed 8 percent of monthly income.

Most lenders, federal and private, mandate that borrowers go through a financial literacy program before borrowing and strongly encourage students and parents to avail themselves of resources such as one-on-one counseling, college fairs, online education portals, college centers or college campus programs that explain loan program differences and the long term consequences of borrowing. Financial literacy is imperative for both parents and students if they want to be informed borrowers.

Comparing student loans