Know the Trade-Offs of Government vs Private Student Loans

Adam Zoll: I'm Adam Zoll for Morningstar.

About two-thirds of today's college students graduate with loans, and mounting student debt has become not just an economic issue, but even a political one.

Here to talk about key considerations when taking out student loans is Peter Herman. Peter is president of Collegian Financial Group, a financial services firm in Northbrook, Ill., that specializes in college planning.

Peter, thanks for being here today.

Peter Herman: I'm happy to be here, Adam.

Zoll: Can you walk us through the preliminaries of the college loan process? When do you need to apply, and what are the steps to do so?

Herman: I have so many people that come to me, after their kids get accepted into college, and they're so happy that they finally made a choice. A lot times we get [a client call], we decided on XYZ college, and besides saying congratulations, we're looking at what is their net cost and how are they going to pay for it?

Now as you alluded to, two thirds of the people have college loans. The parents do not have any information, or the kids, because everything from the financial aid package that was awarded goes to the child. So we have to educate the parents to have the child forward it to them to open up, because they don't understand it, and then possibly forward it to a planner, if they're working with one.

So … loans are part of, unfortunately, the financial aid award, and that's a confusing thing to many people.If I'm getting financial aid or merit money, why are loans included in the award? I think they should be outside and separate, but I'm not going to change what has been historical for the last 20-30 years.

So they get offered loans at the time. The child gets offered what's called a Stafford Loan. The parent is offered a Parent PLUS Loan. They have a choice of not using that, but we'll talk about that in a second, or they are offered sources to go through for private loans, which are your typical banks in the area and your large banks that offer student loans.

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The Stafford loans are in the name of the child, but sometimes, depending upon the income of the parent, some of these Stafford loans could be subsidized. That means the government is paying the interest while the child is in school, and it is deferred until they're out of school, while in the unsubsidized loans, the interest is accruing until the child gets out of school, but the good part of that is, of course, the child--if the parents can pay that off at the time--is building up a good credit record.

So for some parents, that's a way to go, but that is where the first time we're meeting--they're applying usually for those loans in July or August--that's when it's posted on the school's website with the award, and when they can either decide to apply and go through the school … each school has their own process.

Zoll: You mentioned that there could be loans that are offered to the student and/or the parents. What sort of considerations should go into that decision about who should take out the loan?

Herman: The way that we look at is to look at the parents' financial situation. When we started working with a lot of parents years ago, many parents were taking out of their 401(k)s to pay for college. That is definitely the wrong way of going. You have to pay it back in five years; most of the parents cannot. And you've got a taxable income, which also decreases potential financial aid awards.

So, we look at: Is there a benefit to having the loans--meaning the parent, if they do have assets, but their assets are frozen or [they have] limited access or they've depreciated (as some still have), then taking the loans gives flexibility, because a student loan has the benefit of deferral, and an income-based replacement when they get out of school in the student's name. The Parent PLUS Loan is in the name of parent, and those are federal loans, and the other good thing--even though they have,in many cases, higher interest rates than private loans--upon death or disability of the parent, they're wiped out and eliminated, the same thing with the student loan.

There was on TV a couple of years ago, where somebody had a private student loan that they had the student take out with a local banking institution that will remain nameless. Unfortunately the student died in an accident. The parents for years were getting dunning letters because on the private loan they have to pay that back, and the parents did not understand it. So, nobody really explained that [to them beforehand]. And that's one of the things that's important: Understand the difference. Talk to a professional at the school. If you don't get the answers, talk to other people, financial advisers, who understand it, but get the right answers ahead of time, so you won't have a situation like that occur.

Zoll: What are some other key differences between a private and a public loan?

Herman: The private loans, as I started saying, are offered by your major banking institutions, and they have some flexibility, but not the flexibility that the public loans have, but they're lower interest usually. Whereas as the [unsubsidized] Stafford loans … that's another thing, the political fight was over the subsidized interest rate, not the unsubsidized or parent loans … it was at 6.8%; whereas many parents, if they co-sign with their child, might get loans anywhere in the 2% to 4% range on the private loans initially. But the repayment process [on private loans] is more stringent, and it doesn't have as much of the flexibility as the government [loans]. So that's what the parents should look at.

If they don't care about the flexibility, it still builds credit in the student's name, and sometimes it's not a bad thing to do, at least initially, and every year should stand on itself. You may not need to take a loan every year, but you have to reapply.

Zoll: What about guidelines in terms of how much to borrow. We've heard people say things like, you should never borrow more than your entry level salary will be for your career. How do you balance those considerations in terms of academic, what major that student will be pursuing, or what their interests are, versus how much is borrowed?

Herman: That's a real tough question. And every situation really is kind of unique, because you have to look at how much support they are getting from the parents and their grandparents potentially in paying it back. If there is not enough support from the parents [and] it's more on the child, there is an extent to how much [a kid] can get federal money--the rest will be potentially private loans [and] as much grant money [as possible]. [So], you are seeing these kids get out of school with $80,000 or $100,000 before grad school. I am working with loan consolidation with some [clients] in the psychology field of $180,000. And where do they go to pay that back? The problem is, nobody advised upfront [about] what the net result [would be], because what we had [seen] before was a promise [that] professionals [would have] a certain income level; there are no guarantees anymore, unfortunately.

So, a rule of thumb is, as little as possible--let's put it that way. But I understand there are situations where people have to [take more in loans], but understand the potential on the job market is also going to dictate them paying a larger share of their income back, and that may become very difficult. So the key is upfront applying to the right school to have less loans.

Zoll: And how important is it that the student has a clear idea of what they want to do career-wise at that initial stage?

Herman: Great follow-up. That's the biggest thing that we're starting now, because these kids are going into college without a clue. One of the things we're recommending, when they're in high school, is doing an assessment … and having the kid shadow in a certain job.

We had one student with an interest in physical therapy. So we're having them shadow working with a physical therapist to see. If they have a better idea and a clue of their interest and how that can lead to jobs, that's going to help in choosing the right school and not taking as long--getting out in the four years for undergrads, sometimes there's a combination program of five years or combination of six--getting out in a limited period of time with a career in mind. But that starts in high school, not college. So if kids are starting that process in college, it's too late. That's the change.

Zoll: Interesting. Peter thanks very much for joining me today to talk about considerations in taking out student loans.

Herman: Thank you for inviting me.

Zoll: For Morningstar, I'm Adam Zoll.