Get smart about borrowing for college
The credit crisis has narrowed the options. Here's a guide to the best deals.
(Fortune Magazine) -- By now, most college-bound high school seniors have accepted an admissions offer and are cruising blissfully toward graduation, summer, and their chosen campus come fall. For parents, on the other hand, the hard work of financing this education is just beginning.
At the most expensive schools, the annual bill for tuition plus room and board can run to $50,000, and the average cost ranges from $34,000 a year at private colleges to $14,000 at public universities - daunting figures made even scarier by a deepening recession. What's more, some of the assets many affluent families counted on to help defray education expenses, such as investments and home equity, have suffered large losses in value.
"Even parents who thought they were fully funded for college are now trying to determine how to fill these gaps," says Deborah Fox, founder of Fox College Funding, a consultancy based in San Diego that works on college planning with high-income families.
One solution for many students will be to borrow. But the credit crisis, combined with congressional action, has led to big shakeups in the student-lending industry over the past two years. One blow came when Congress cut subsidies to private lenders that issue government-backed student loans through the Federal Family Education Loan Program. Then the student loan business lost a crucial source of capital when investors soured on all types of asset-backed securities, including bonds backed by student loans, in the wake of the subprime mortgage mess.
The Department of Education has picked up the slack by buying federal loans. Even with that support, the industry is shrinking: Since July 2007, 45 lenders have stopped making private loans, and more than 160 lenders have suspended their federal loan programs, according to Mark Kantrowitz of FinAid.org. And now a key provision in the Obama administration's new budget aims to eliminate private origination of federal loans altogether to let all students borrow directly from the government through their colleges.
The proposal, if passed, won't kick in until 2010. This year, meanwhile, borrowers face fewer options, and fewer bargains too. Here are some simple tips for navigating the new student loan landscape.
There are ample reasons to dread the cumbersome Free Application for Federal Student Aid (FAFSA). "It's too long, too confusing, and too complicated," says Lauren Asher, acting president of the Project on Student Debt. That's why many families, especially those whose income may disqualify them from need-based grants, are tempted to skip the form altogether. But that would be a mistake. Besides being the gateway to scholarships and grants, the FAFSA opens the door to unsubsidized government-backed loans. Filing the form is also a smart insurance policy, especially in a tough economic environment. "It's always good to be able to fall back on federal loans with competitive rates," says college consultant Fox. "Even midyear, if a parent loses a job it can be comforting to know there's at least that option." And don't worry if you haven't filed one yet: It's not too late. Colleges set their FAFSA deadlines early to draw up financial aid offers, but you can file anytime during the academic year if you decide that you want to apply for a federal loan.
Even if you don't qualify for the subsidized version, a government-backed Stafford loan is "cheaper and has better repayment terms" than most other loans, says FinAid.org's Kantrowitz. The unsubsidized Stafford loan is available to all students, regardless of family income or credit score, and has a fixed interest rate of 6.8%. That's a sweet deal, but the catch is the annual limit: $5,500 for freshmen, $6,500 for sophomores, and $7,500 for juniors and seniors.
The federal PLUS loan, which lets families borrow up to the full cost of tuition, room, and board, has always been a solid option. The credit requirements are minimal, and parents can defer repayment until graduation (though interest continues to accrue). If your child's college already participates in the direct loan program, you can take out the PLUS at a fixed rate of 7.9%; otherwise the rate is 8.5%. This year families won't be able to do much comparison shopping for federal loans among private lenders, which in the past competed by waiving origination fees and offering other reductions. "Loan discounts have all but evaporated," says Kantrowitz. One that's still available is a 0.25% rate cut for automatic payments from your checking account.
Even with declining real estate values, home-equity loans may still make sense for some families. Interest on home-equity loans of up to $100,000 used for education expenses can be tax-deductible (unless you are subject to the alternative minimum tax). "The average fixed-rate home-equity loan is pretty high right now at about 8.6%," says Greg McBride, a senior analyst at Bankrate.com. "That's comparable to the PLUS loan, but the difference for the parent who's in the 25% federal marginal tax bracket is that the after-tax rate works out to 6.5%." You can get a lower initial rate with a home-equity line of credit, but McBride warns that if you use a HELOC, you must plan for the inevitable rate hikes.
If a home-equity loan is out of the question, there are alternatives. For instance, the Massachusetts Educational Financing Authority, a nonprofit state agency, is still offering private loans at competitive rates to residents or students who attend a Massachusetts university. (Other states have similar programs, but some, like Michigan, have suspended lending because of tight credit markets.) Fox also recommends checking with the financial aid office to find out whether the college has any funds set aside for borrowers. "Some schools have been offering their own loan programs to help parents through a difficult time, and the interest rates are typically lower than on a PLUS loan," she says.
Dozens of lenders have stopped issuing private education loans, and most that remain have been raising rates and eligibility requirements. Also, they tend to carry variable rates, so make sure you read the fine print. "Short-term interest rates are at record lows, and the likelihood is that rates will be higher in future years," says McBride. "Don't fall into the trap that many mortgage borrowers fell into when they focused on the introductory rate without looking down the road."