A Study Guide for Student Loans

Adam Zoll: I'm Adam Zoll for Morningstar. While many high school seniors are nervously watching mailboxes for college acceptance letters, many parents are nervously watching their wallets, wondering how they'll pay for the high cost of higher education. For many families, taking out loans is a necessity.

Here to talk about the college loan landscape is Mark Kantrowitz. Mark is the publisher of FinAid.org and Fastweb, two websites dedicated to providing information on college funding options. Mark, thanks for joining us today.

Mark Kantrowitz: Thank you for having me.

Zoll: Mark, for those who may not be familiar with the variety of college loan types that are out there, can you give us a quick overview of some of the different types of loans and for whom those might be best-suited?

Kantrowitz: There's two main types of student loans. There are federal student loans, which are made by the federal government, and then there are private student loans that are also known as alternative student loans, which are made by banks and other financial institutions. The terms of those loans are set by those particular lenders.

The federal government offers several different loan programs, the most popular of which is the Stafford loan program that has a 6.8% interest rate that is fixed. There is a subsidized version for students who have financial need, which currently has a 3.4% interest rate, but new loans starting July 1 will have a 6.8% interest rate.

There are also parent loans, such as a Parent PLUS Loan, which is a federal loan made to parents of undergraduate students, and the Perkins Loan, which is made to students with exceptional financial need.

Zoll: For families who are trying to figure out which of these different kinds of loan types is going to be the best fit for them in their circumstance, where would you recommend starting your research?

Kantrowitz: Well, they should borrow federal loans first, because the federal loans are cheaper and more available, and they have better repayment terms than the private student loans. Even though, the 6.8% interest rate on the Stafford loan may seem high compared with home equity loans of 4.0% or even less, the federal loan has a fixed rate whereas those other loans have variable rates, and right now the interest rates are in an unusually low interest-rate environment. They have nowhere to go but up. The equivalent fixed-rate to a variable-rate loan involves adding 4 to 5 percentage points to that interest rate, plus the home equity loan is secured by the home. If you default on that loan, you can lose the home, whereas if you default on a student loan, they can't repossess your education. So, there's different mix of risks.

Also the federal loans offer a variety of repayment benefits, such as deferments and forbearances, income-based repayment, and public service loan forgiveness, that aren't offered by the private student loans.

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Zoll: What are some of the factors that help determine college loan availability for students?

Kantrowitz: Well, for the Stafford loan, it doesn't look at your credit score. All you have to be is a U.S. citizen or permanent resident, and you are eligible for these loans. There are two types of Stafford loans, subsidized and unsubsidized. The subsidized loans are based on financial need. The unsubsidized loans are available to anybody without regard to financial need; you can be rich and still get these loans.

With the subsidized loans, the main difference between them and the unsubsidized loans is the government pays the interest on the subsidized loans while you are in school. The Parent PLUS Loan does depend on the borrowers' credit history. It's a very modest credit check. It's looking for the absence of an adverse credit history, such as having had a bankruptcy discharge, a foreclosure or repossession in the last five years, or current delinquency of 90 or more days on any debt. It doesn't depend on debt-to-income levels; it doesn't depend on your credit score. It's fairly easy for most families to qualify for that loan.

Private student loans on the other hand do depend on your credit score, and many of them require a credit-worthy co-signer since few students have enough of a credit history or good enough of a credit history in order to qualify.

Zoll: Along those lines, what are some of the considerations that families should be asking themselves in terms of deciding whether to take out a parent loan or a loan in the student's name?

Kantrowitz: The main consideration should be cost. The student loans are less expensive than the parent loans, so you should line up the loans according to the interest rates, and pick the loan with the lowest interest rate first. The Stafford loan has annual and aggregate loan limits. For a dependent, undergraduate student it starts off with a $5,500 annual loan limit. That increases to $7,500 when the student is a junior or senior in college. That may not be enough money to pay for the college cost in which case the Parent PLUS loan is a reasonable option. It's available up to the full cost of education minus other aid received. Something that should be paid attention to, though, is to not borrow too much money to pay for school.

If you find yourself with no choice but to borrow from a Parent PLUS loan program or a private student loan program, that may be a sign that you are overborrowing and should consider ways to reduce that debt. One of the best ways to save on college cost is to enroll at an in-state public college instead of a higher-cost private college.

As a good general rule, your total education debt at graduation should be less than your expected annual starting salary and ideally a lot less. So, if your total debt is less than your annual income, you'll be able to pay back that debt in about 10 years. If your total debt exceeds your annual income, you're going to need an alternate repayment plan like income-based repayment or extended repayment in order to afford the monthly loan payments.

So, definitely try to find ways to minimize that debt. It may involve, as I said, enrolling in an in-state public college instead of a higher-cost college, living at home with your parents, buying used textbooks or selling the textbooks back to the bookstore at the end of the semester, minimizing trips home from school, not going out on vacation on spring break, and also minimizing personal expenses. For example, if you don't like the cafeteria food that you paid for, the meal plan, and you eat out once a week, $10 pizza once a week, that's $2,000 by the time you graduate. And if you use student loan money to pay for that, that $2,000 will cost you about $4,000 by the time that you repay the debt because every dollar you borrow is going to cost you about $2 by the time you pay back the loans.

So before you spend student loan money on anything, double the price and ask yourself if you'd still buy it at twice the price because that's realistically what it's going to cost you.

Zoll: Mark, what does it take to qualify for need-based loans that have more favorable loan terms?

Kantrowitz: Financial need is the difference between the cost of attendance, the total cost of college for one year, and the expected family contribution, which is a measure of the family's financial strength. Obviously, the lower your expected family contribution, the greater your financial need, but also the higher the cost of attendance, the higher financial need.

So, low-income students will probably qualify for a subsidized Stafford loan at any college, while middle- and upper-income students will only qualify for subsidized loans at the more expensive colleges.

Zoll: I know that Chase recently announced that it's not going to be accepting any more new private student loans. Do you see a trend away from the private loans and toward more of the publicly available loans?

Kantrowitz: J.P. Morgan Chase and U.S. Bancorp both recently ended their private student loan programs. I think that's the last of the lenders leaving the private student loan programs for now. During the credit crisis, a lot of nonbank lenders left the student loan programs. So today we have mostly banks offering private student loans. There was also a shift from private loans to federal loans during the past few years.

In 2008, the federal loan limits were increasing. The annual and aggregate loan limits on federal education loans were increased for the first time since 1992, and that led to a shifting of borrowing from private loans to federal. Back then, almost a quarter of new loans were from the private student loan programs. Today less than 10% of new loan volume comes from private student loans.

Zoll: Well, Mark, thanks for being with us today and sharing your insights on student loans.

Kantrowitz: Thank you for having me.

Zoll: For Morningstar, I'm Adam Zoll.