Part 3: Paying for College

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We all have heard what a serious problem student loan debt is. After all, there is currently $1.75 TRILLION outstanding with an average of just under $29,000 per borrower. More than half of students leave college with student loan debt. That debt often takes a decade or more to repay, putting a strain on the monthly budget of young adults as well as starting them off behind on their long term financial goals and retirement saving.

When I taught my first Personal Finance class back in 2021, I had a class of high school seniors. Many were planning on using student loans to pay for college. After all, they have become completely normalized in our society because the ever increasing cost of college is out of reach for many families to afford. Almost all of my seniors in that class that were planning on using student loans either found another way to pay for college such as starting at a community college to knock out core classes then transferring or they greatly reduced the amount of student loan debt they were going to take on.

If you use that national average amount that I just mentioned of almost $29,000 and use a 5% interest rate and a standard 10 year repayment plan, the monthly payment would be right at $300 for those 10 years. However, if you were able to graduate without student loan debt at say age 22 and immediately began investing $300 per month at 7.5% annual return (This is well below the 10 year stock market average) then you would have nearly $53,000 at age 32. If you left that $53,000 invested and did not invest any more towards it, that $53,000 would grow to about $465,000 by age 62. A total of $36,000 of contributions from age 22 to 32 and it becomes $465,000 by age 62. On the flip side, if you have to pay off a student loan for 10 years and can’t save and invest until age 32 then when you start investing at that $300 a month at age 32, it would take you until about age 64 for it to have grown to $465,000. You would be making that $300 a month investment for over 30 years! Your total contribution would have been $115,200 rather than just $36,000. When I give students these kinds of numbers and how drastically student loan debt can impair their long term financial goals they want to eliminate or minimize student loan debt.

Few students (or their families) truly understand what they are signing up for when they take out a student loan. We could talk for hours about student loans but today I am going to give you an overview of the types of student loans as well as their repayment plans.

As you may recall from the first two episodes in this series we talked about the FAFSA, the Free Application for Federal Student Aid. You want to get this completed as soon as it opens up for the following school year that you are applying for. The FAFSA will give you that EFC number, the Expected Family Contribution, (don’t forget this term is changing to the Student Aid Index in 2024). In talking with some parents recently, their EFC turned out to be much higher than they were anticipating it to be. That is when it is good to have that 529 plan we talked about last week or some other kind of college savings set aside. When your child applies to college, the school will have a published Cost of Attendance, a sticker price, and then the net price will be the price after financial aid is applied. We generally think of financial aid as aid that does not need to be repaid like a grant but some student loans are actually classified as financial aid. The FAFSA helps determine the amount of aid a student is eligible to receive based on their financial need. Often times there is a gap between the net price and the EFC where additional funds are needed. Plus, families often don’t have enough funds to cover their EFC. This is where student loans come in.

There are both federal and private student loans. Federal loans make up about 92% of total student loans and are generally more favorable towards the borrower. Private student loans are generally thought about as a “last resort” if federal loans have been exhausted.

Let’s look at the federal loans first.

The most favorable type is the Direct Subsidized. This type is based on financial need. The school will tell you if you are eligible and how much you are eligible for. The beauty of this type is that the government covers the interest while you are in school (at least part time), during the grace period, and during any deferment periods.

Next is the Direct Unsubsidized. This type is not based on financial need. It will usually have a slightly higher interest rate than the subsidized and there are loan limits. The big thing here is that the borrower is responsible for all interest that accrues while you are in school, during grace periods, deferments, etc.

Both the Direct Subsidized and Unsubsidized have a fixed interest rate and do not require a credit check. Repayment plans generally begin about 6 months after graduation.

Next is a Direct PLUS Loan. This is where the Parent Plus loan comes in. This loan is taken out by parents of undergraduate students. It is intended to fill the gap between the COA (Cost of Attendance) and any Direct Subsidized or Unsubsidized loans or financial aid received. The limit available is the COA minus financial aid received. These generally have a higher interest rate and the payments start immediately upon disbursement unless you apply for deferment. However, interest still accrues during the deferment. These loans are not eligible for income driven repayment. The parent is the responsible party for the loan repayment.

Next up is a Direct Consolidation loan. This is when you combine all eligible federal loans down into one. Having one payment to manage is a way to simplify. It usually creates a lower monthly payment but increases the length of time to repay thus increasing overall interest paid. This is usually done after you have left school. The interest rate is based upon a weighted average of the consolidated loans. This is eligible for income driven repayment. However, depending on the type of loans you are consolidating, you want to make sure you won’t lose credit for any payments that have already been made on the pre-existing loans.

Private student loans are a consideration when all federal loan options have been exhausted. They are generally less flexible, have higher interest rates (that could be fixed or variable) and they do require a credit check, meaning most students will need a co-signor in order to obtain one. They can cover any costs and limits are dependent on the lender and the loan but you do want to make sure that the lender does work with your intended school.

There are also Private Refinancing options that may allow you to get a lower rate if your credit has improved during the meantime.

Current interest rates as of today are averaging about 5% for the federal direct loans, 7.5% for the Plus loans, and a range of 5.6-13.8% for private loans. You can see how those private loans especially could get quite expensive.

What are the repayment options for these loans?

For the Federal Direct Loans (both subsidized and unsubsidized) repayment starts 6 months after you graduate or have gone less than part time. For the unsubsidized, the interest is still accruing during that time. As mentioned above, the Parent Plus loan the payments start at disbursement unless a deferment until after graduation is applied for (but the interest still accrues).

The Standard Federal Plan is 10 years of repayment with the same monthly payment for those 10 years. This is what automatically happens unless another plan is decided. The Graduated Plan is the same 10 year time frame but the payment starts small and increases over the 10 years. The Extended Plan allows up to 25 years for repayment with either a fixed or graduated monthly payment. The Federal Direct Consolidation plan is for the repayment of a Direct Consolidated loan and allows up to 30 years to repay.

Federal loans (except for the Plus loan) are eligible for Income Driven Repayment. You can do the Direct Consolidation loan and consolidate your Parent Plus loan into that and be eligible for Income Driven Repayment. This plan is usually 10% of your discretionary income over a term of 20 years. There are also 15% and 25 year options and a 20% of discretionary income for 25 years. Discretionary income in this context is calculated as the difference between your annual income and 150% of the poverty guideline for your state of residence and family size. Payments under this plan may not fully cover the interest so the unpaid interest is added to the principal thus increasing the principal balance each month the interest isn’t fully covered by the payment.

Private repayment plans vary by the lender and the terms of the specific loan. Some have the payments start when the loan in disbursed and some have interest only payments while you are in school. The average private student loan has a repayment term of 7-15 years but they can be anywhere from 5-20.

All in all, if you need student loans you generally want to exhaust your federal loan options before choosing a private student loan. You want to take out as little as absolutely possible in total and repay it on the shortest term you can afford. It is easy to see how people have an extremely hard time obtaining their long term financial goals when they are spending up to 25 years repaying student loans rather than being able to save and invest their money. The long term considerations of student loan debt need to be thoroughly evaluated before taking it on. Options to make the degree less expensive such as community college then transfer to a 4 year school, working while in school, and work-study programs all should be considered. That dream school may financially kill your long term wealth dreams so always keep options open. A good rule of thumb is not to graduate with more student loan debt than what your starting salary will most likely be.

The bottom line, college is expensive. Do your research before you commit to a school or any loan. Remember, colleges have a net price estimator on their websites. And don’t forget to get that FAFSA filled out as soon as you are eligible to! The future is wide open, don’t narrow it with overwhelming student loan debt!