Assessing the Student Loan Landscape

Question: My son is getting ready to apply to colleges, and I suspect that our savings plus any financial aid that we're eligible for may not cover all of his expenses. What do we need to know when shopping for student loans?

Answer: In the past, many people put their student loans in the "good debt" column: Because the rates on these loans were typically quite low, it didn't often make sense to prioritize paying them off over other financial objectives, such as investing for retirement.

These days, however, those borrowing to pay for college need to be a lot more defensive. Not only may student-loan terms be less attractive than they were in the past--particularly for those who need to go to the private market to secure one--but new grads may also get squeezed if they have to begin repaying their loans before they land a job. Owing in no small part to the still-anemic economic recovery, the student loan default rate has been on the rise, recently jumping from 7% to nearly 9% for new grads with loans, according to the U.S. Department of Education. (High default rates among graduates of for-profit colleges push up the averages.)

As with mortgage borrowers, student-loan shoppers face a bewildering array of options that carry varying interest rates, fees, and terms. In all, it pays to do your homework--and investigate other alternatives--before signing on the dotted line for a student loan.

Determine Your Need
The first step in the college-funding process is to determine how much of your child's education expenses your family will likely be on the hook for. Submitting the Free Application for Federal Student Aid (FAFSA) is the way to officially check on financial aid eligibility, and your specific package will vary by school. That means you'll have to wait until acceptance letters start rolling in to get a true handle on how much of your child's college bills will be covered by grants, scholarships, and/or work-study programs and how much you'll have to cough up on your own, either by dipping into savings or taking out loans. However, you can also use online calculators such as the Quick EFC (Estimated Family Contribution) Calculator to help assess these variables in advance of submitting applications and filing your FAFSA form.

Discuss the Payoff
If it looks like you and/or your child will have to borrow a sizable sum to cover the cost of college, it's wise to begin discussing those numbers in the context of your child's expected career path. If your child will graduate with $100,000 in student-loan debt but plans to venture into a field where starting salaries are in the $25,000 per year range, it doesn't take a math major to see that it will take many years to retire that debt, and doing so could impede your child's ability to reach other financial goals. This calculator enables you to stress-test various loan amounts based on anticipated salary level. If the loan amount needed to finance a given school appears unaffordable based on your child's anticipated career path, it's better to have that discussion when there's still time to enroll in a cheaper school.

Know the Different Types
College loans come in a number of different varieties, but there are a few key categories to be aware of. The first choice for most students seeking additional funding are those extended by the federal government. Perkins loans are available exclusively to low-income students. Stafford loans, meanwhile, come in two key varieties. With subsidized Stafford loans, students aren't on the hook for interest until after graduation, whereas interest begins accruing on unsubsidized Stafford loans immediately. Students applying for subsidized Stafford loans must demonstrate financial need, whereas students needn't demonstrate a financial need to qualify for an unsubsidized Stafford loan. (Many students combine both subsidized and unsubsidized loans.) Loan limits apply to all federal student loans, however, as laid out in this table, so many students will have trouble covering all of their costs by exclusively relying on these loans.

The second key category is federal loans made directly to parents, usually called PLUS loans. On the positive side, parents can typically borrow much more than students. However, interest begins accruing immediately and payments must also begin immediately. Moreover, the cost of a PLUS loan is apt be higher than other forms of financing that a parent might secure, such as a home equity loan, and paying down such a loan may impede the parent's ability to save for other financial goals.

The final category of student loan is a private loan extended by a bank. In general, the cost of a private student loan will be much higher than a federal loan. Finaid.org's website includes an excellent table to help compare the rates, terms, fees, and loan limits associated with various college-loan products, and you can also use sites like bankrate.com to comparison-shop among different products. Without doing a deep dive, you can readily see that private loans are costly: Often keyed off of the one- or three-month LIBOR or the prime rate, interest rates on private student loans are frequently in the double-digit range.

Don't Overestimate the Value of the Interest Deduction
You may have heard that you'll be eligible to deduct the interest on student loan debt. That's true, but don't overestimate the value of that deduction. In 2011, you can only deduct $2,500 in student loan interest per year; single parents earning more than $75,000 and married couples filing jointly who earn more than $150,000 per year cannot deduct the interest at all.  

Consider Additional Options
Rather than assuming student loans are the only way to cover the cost of college, it's important to take a step back. Fully exploring financial aid packages, scholarships, and work-study programs can help reduce the strain that such loans can impose on families and new grads; some grandparents may also have the wherewithal to help defray college costs. Parents may also contemplate tapping home equity lines of credit or using their Roth IRAs to fund college; this Morningstar.com article discusses some of the pros and cons of these alternative forms of college financing.

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