Choosing an Education Loan

Most families evaluate education loans based mainly on cash flow considerations: • How much money can you get to pay for college costs and/or living expenses? • How much are the monthly payments? • When do the payments start and when do they end? • What is the total cost of the loan (total payments over the life of the loan)? • Who is responsible for paying back the loan? This article summarizes some of the key characteristics of student loans according to their impact on these considerations. While the quality of customer service may be worth considering, the cost of the loan is usually the most important criterion.

Choosing an Education Loan

The more you know about student loans, the better you are equipped to borrow money to pay for school.

Eligible Expenses and Loan Limits

Most education loans permit the borrower to use the loan funds to pay for any expenses in the official cost of attendance. The cost of attendance, sometimes called the student budget, includes tuition and fees, required books and supplies, room and board (for students enrolled at least half time) and transportation and personal expenses. Some private student loans may limit the loan to institutional charges (i.e., just tuition and fees) especially if the borrower has marginal credit. The loan may also have annual and aggregate loan limits. The annual loan limit is the maximum amount you can borrow per year. The aggregate loan limit is the maximum amount you can borrow in total. In some cases, the aggregate limit applies to just the individual loan program while in other cases the aggregate limit applies to all education debt. For example, the Federal PLUS loan has an annual limit of the cost of attendance minus other aid received and no aggregate limit. The unsubsidized Federal Stafford loan for undergraduate students has annual limits that range from $5,500 to $7,500 for dependent students and $9,500 to $12,500 for independent students, and aggregate limits of $31,000 (dependent students) and $57,500 (independent students). Most private and all federal education loans are school-certified, meaning that the college verifies that the student is enrolled and determines the maximum amount the student is eligible to borrow. Private student loan programs may reduce this amount based on credit criteria.

Student Loan Repayment

Education loans typically specify three time periods: the in-school period, the grace period, and the repayment period. Most loans do not require the borrower to begin making payments while they are still in school. Some loans provide for a 6- or 9-month grace period after graduation during which the borrower is not required to begin making payments. During the repayment period, however, the borrower must make monthly payments of principal and interest or they will be considered delinquent (failure to make a payment on time) or in default (failure to make a payment for 120 days on a private student loan or 270 days on a federal education loan). Certain federal student loans are subsidized, which means that the federal government pays the interest during the in-school and grace periods. All other loans — including the unsubsidized Stafford loan, the PLUS loan and private student loans — are unsubsidized.

Unsubsidized Loans and Interest

On unsubsidized loans, interest continues to accrue and is the responsibility of the borrower. If the borrower chooses, the interest can be deferred by capitalizing it. This adds the interest to the loan balance, increasing the size of the loan. It is a form of negative amortization, in which the loan keeps on getting bigger and bigger. In all cases borrowers can begin making payments sooner if they wish, since education loans do not have prepayment penalties. Borrowers can choose to make payments of the interest as it accrues or payments of principal and interest, or they can defer payments of principal and interest until they enter repayment. It is a good idea to pay at least the interest during the in-school and grace periods to prevent the loan from growing. Some private student loan lenders will give the borrower a small discount on the interest rate or fees if the borrower commits to paying the interest during the in-school and grace periods. Other private student loan programs require borrowers to make interest-only payments during the in-school and grace periods. This keeps the borrower informed about the amounts borrowed and the cost of the loan, discourages overborrowing, and helps the borrower establish good credit while they are still in school.

Loan Terms and Loan Repayment Plans

The loan term is the number of years the loan will be in repayment. This affects the size of the monthly payment. A longer loan term reduces the size of the monthly payment, but increases the total interest paid over the life of the loan. For example, increasing the loan term on a federal loan from 10 years to 20 years cuts the monthly payment by about a third (34%), but more than doubles the total interest paid over the life of the loan (a factor of 2.18 increase in the total interest). It is best to stick with the shortest loan term you can. Federal education loans offer several different repayment programs:

Standard Repayment

Standard repayment uses level payments for a 10-year term. The monthly payments are the same and exceed the interest that accrues. The payments are first applied to interest and then to reducing the principal balance of the loan.

Graduated Repayment

Extended Repayment To qualify for this plan, you must have at least $30,000 in student loan debt. Payments can be either fixed or graduated.

Saving on a Valuable Education (SAVE – formerly REPAYE)

Under this plan, monthly payments are set at 10% of discretionary income, which is defined as income after taxes, bills, and everyday expenses are considered. Payments are recalculated each year after determining income and family size. Outstanding loan balances are forgiven after 20 years for undergraduate studies and 25 years for graduate studies.

Pay as You Earn Repayment (PAYE)

Monthly payments are set at 10% of discretionary income and borrowers are never expected to pay more than they would under the Standard Repayment Plan. Each year, monthly payments are recalculated according to income and family size.

Income-Based Repayment

This particular payment plan is for borrowers with a high debt-to-income ratio. Payments will be set at 10 – 15% of discretionary income and will be recalculated each year according to income and family size. After 20 – 25 years, depending on when the loan was first established, the loans will be forgiven.

Income-Contingent Repayment

Payments under this plan are determined by whichever is the lesser: • 20% of discretionary income • The amount that would be paid on a repayment plan with a fixed payment over 12 years, adjusted for income.

Income-Sensitive Repayment

This final repayment option is only open to Federal Family Education Loan programs. Payment is based on annual income; however, it will be paid off within 15 years.

Cost of the Loan

Besides the loan term, the interest rates, origination fees and default fees have the biggest impact on the cost of the loan. The interest rate is a fee charged annually (or monthly) based on a percentage of the outstanding balance owed on the loan. The origination and default fees are one-time fees charged up-front based on the initial balance of the loan. These fees are always deducted from the disbursement check and are never collected in advance. (If someone asks you to pay the loan fees in advance, it can be a warning sign of an advance fee loan scam.) Some lenders offer discounts on the interest rates and fees. These discounts are often small and may have stringent requirements for continued receipt. The most common discount is a 0.25% interest rate reduction for having the monthly payments automatically debited from your bank account. All else being equal, you should focus on the lowest cost loan. This is usually the loan with the lowest no-fee equivalent interest rate. It may be affected by the deductibility of interest on the loan. Up to $2,500 in interest paid on qualified education loans may be deducted as an above-the-line exclusion from income of federal income tax returns. This means you can take the deduction, which reduces your adjusted gross income, even if you don't itemize on Schedule A. TIP: Fastweb provides a loan payment calculator you can use to calculate the monthly payments on a loan.

Who is Responsible for Student Loan Repayment?

Usually either the student or the parent is responsible for repaying the loan. Direct subsidized and unsubsidized are student loans, while the Parent PLUS loan is a parent loan. Private student loans are usually student loans, but since students may not have strong enough credit to qualify for the loan, a cosigner may be required. A cosigner is a co-borrower and is equally responsible for repaying the loan. If the student borrower is delinquent or defaults on a cosigned loan, the lender may seek repayment from the cosigner. The repayment history (including any late payments) on a cosigned loan is reported on the credit history of both the borrower and cosigner and will affect both their credit scores.

How to Choose a Student Loan That's Right for You

When it comes to student loans, you have choices. Here’s what to consider: • Loan types: There are really only two options, or sources, for student loans: federal student loans and private student loans. It’s best to borrow federal first as these loans have lower interest rates and will save you more over time. However, many students will find that they need private student loans as well because of the loan limits on federal loans. • Loan limits: You can only borrow a specific amount of student loans from the federal government each year. The loan limit depends on your financial need, year in school, and type of federal student loan, i.e. subsidized vs. unsubsidized student loan. • Repayment plans: There are multiple repayment plan options for both federal and private student loans. You can choose a repayment plan based on your income after graduation. Remember that certain jobs in public service fields may enable you to qualify for public service loan forgiveness. • Full cost of the loan: Finally, don’t forget that there’s more to the loan than the amount you borrow. Consider interest, origination fees, and default fees. All of this will have to be paid back in addition to the loan balance. Still have questions? See also Fastweb's Quick Reference Guide on Choosing a Student or Parent Loan.