Choosing a college loan requires careful attention

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 07/27/22


With summer in full swing, thoughts of college aren’t far away for many families.

Indeed, families of college-bound students starting in the fall may be looking at their first tuition bill due in August.

Most families rely on multiple sources to cover tuition payments, including college savings accounts, scholarships, funds from other savings or investment accounts, and loans.

Before making a decision around borrowing, it is important to understand the landscape for taking out a college loan.

Here are the main options for borrowers.

Direct federal student loans

There are two types of direct loans. Subsidized loans are based on financial need. Interest doesn’t start accruing until after graduation or the student stops going to school at least half-time. Unsubsidized loans are available to all students, regardless of financial need, but interest accrues immediately. Both types of loans require repayment six months after the student leaves school.

For both loans, parents do not need to co-sign. This can benefit the parent’s credit situation. Generally, interest rates and fees are competitive. Interest rates are fixed for the term of the loan, which is usually paid off in 10 years. Currently, interest rates for undergraduate students are around 5% with a 1% origination fee. The amount the borrower can take is based on the cost of attending the school, the year in school, and the student’s status as a dependent or independent. A graduate or professional student can borrow up to $20,500 each year in Direct Unsubsidized Loans.

Federal Direct PLUS loans

Available to parents and graduate or professional students, the interest rates and fees for Direct Plus loans are higher than direct student loans. Interest accrues immediately. Eligible parents must be the biological or adoptive parent of a student enrolled at least half-time at an eligible school. Grandparents, even if they are the custodial parents responsible for the student, are not eligible to borrow parent PLUS loans.

The loans are not based on financial need. The maximum PLUS loan amount is based on the cost of attendance (determined by the school) minus any other financial aid received. If you request a deferment, payments will not be required if the student is enrolled at least half-time and for an additional six months after the student graduates, leaves school, or drops below half-time enrollment.

During any period when payments are not required, interest will accrue on the loan. Current interest rates are over 7% with origination fees around 4%.

The loan requires a credit check. If unable to pass the credit check, a borrower can still be approved for a PLUS loan if they obtain an endorser or are approved by the Department of Education with an explanation of extenuating circumstances related to their adverse credit history.

A Direct PLUS Loan made to a parent cannot be transferred to the child. However, these loans can qualify for federal loan forgiveness programs.

Private student loans

Private student loans are generally more expensive than federal student loans.

Offered by banks and other financial institutions, these loans do not benefit from federal forgiveness or deferment programs, or automatic cancellation provisions due to death or disability.

However, private loans can come with different terms including a variable rate structure or a rate based on credit score. The loans generally offer more options for repayment terms. Many private student loans require payments while the student is still in school. Still, some will allow the student to defer payments while in school. Private loans can be used to help cover secondary expenses such as room and board, textbooks, class-related equipment, and school supplies.

Looking at the current interest rates on student loans

Fixed-rate loans have locked-in interest rates that will not change for the life of the loan. Currently, these are the rates for the main loan types for the 2022 fiscal year.

Interest rates for direct loans

(First disbursed between July 1, 2022, and July 1, 2023)

Loan type Borrower type Fixed interest rate
Direct subsidized loans and direct unsubsidized loans Undergraduate 4.99%
Direct unsubsidized loans Graduate or professional 6.54%
Direct PLUS loans Parents and graduate or professional students 7.54%

Source: U.S. Department of Education. All interest rates in the table are fixed rate. A fixed rate will not change for the life of the loan.

Emergency relief extended for existing loans

On April 6, 2022, the Department of Education extended Covid-19 emergency relief for existing student loans through August 31, 2022. This temporary provision includes the following measures for eligible loans:
  • A suspension of loan payments
  • A 0% interest rate
  • Stopped collections on defaulted loans

Rising rates impact borrowing

As the Fed works to rein in inflation, many anticipate interest rates to continue to rise. Student loan borrowers should pay close attention to interest rates because rates can dramatically add cost to student loans over time. Borrowers should know the exact interest rates on each of their loans before and after taking out loans. They should also be aware of how much their total debt is, and what their average payments will be.

Review plan with an advisor

Most families use a combination of options to pay for college, including 529 college savings plans, personal savings, financial aid, and different forms of debt. In its 2021 report, Sallie Mae found the largest portion of college costs — 45% — is paid from family savings and income, followed by scholarships and grants (25%), student borrowing (11%), parent borrowing (9%), student savings and income (8%), and relatives and friends (2%).

If parents begin planning early for college saving, it’s important for them to review their overall college funding strategy with an advisor as it gets closer to the start of college. Interest rates, inflation, and other temporary federal aid programs can impact how families save and the best way to start spending.

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