College Loans 101

April 1, 2004- "How hard can it really be?" I thought smugly when I started pulling together all the pieces of the financial application process for my daughter's first year at college. After all, I passed all four parts of the CPA exam in one sitting, and I relentlessly take continuing education on all things financial. And haven't I advised my clients for over 25 years on the basics of education planning--saving early, using home equity loans, scholarships, 529 plans? Plus there is so much help available today, from financial assistance centers at colleges to Web sites and phone operators.

I soon found out the hard way how hard it really is. A bewildering mountain of options are available for financing a college education today, and planners should study up on them so they have the smarts to guide their clients through this stressful process.

One of the most important financing tools is a program called Parent Plus, a federal program that any lender can choose to offer (including Sallie Mae, the government organization that lends money for college). It is the code word for a loan that is given to the parents of a college student. Parent Plus is not a needs-based financing program; it is open to everyone based on credit history. When qualified, the Parent Plus lender coordinates with the college's financial aid office to determine the exact amount of the loan. The Parent Plus loan has a 3% fee that gets paid to the Department of Education.

Once the final payment to the college for the year is made (usually in December or January), the repayment cycle of the program begins (generally 60 days after the final payment). The basic repayment period is over 10 years. There are three options for repayment:

• Begin principal and interest payments in the year the loan is made;
• Pay only interest and pay principal and interest after 48 months; or
• Make no payments and begin paying principal and interest after 48 months for 10 years.

The three charts in "Payback Time" below illustrate how each of these options would work, assuming that a student has a $5,000 scholarship, the financial aid office estimates costs of $30,000, and the interest rate is 4.22%. In this case, the total amount borrowed would be $25,000, plus the 3% fee ($750), for a total one-year financing of $25,750. If you are using the first option (principal and interest payments), the monthly payment due to the lender on Feb. 1, estimated over 10 years, would be approximately $263.41 per month.

If you don't like the option of paying everything immediately, you can elect the second option (paying interest only). Using this option, interest-only monthly payments would be $90.55 compared to $263.41 for a 10-year principal and interest loan. The interest-only election can be made only for the years the student is in college. Because no principal has yet been paid, the monthly payments will be higher in years five through 10 as you pay off the loan (assuming that the rate remains constant at 4.22%, the monthly payments beginning in year five would be $1,621.80 for 72 months).

The third option for repaying the loan is to request forbearance. That's the term lenders use to describe a request to pay nothing while your child is still in school. The interest gets added to the principal, creating a bigger loan to repay as well as higher monthly payments once the repayment begins. So with 72 months left on a 10-year schedule (120 months minus 48 months deferred), you will begin repaying $114,337. The monthly payment (again assuming a 4.22% rate) is $1,800.30. If you choose the forbearance option, you don't lose the ability to pay the loan over 10 years. Over the full 10-year term, payments will be $1,169.60 for the $114,337 loan.

If 10 years isn't long enough to repay the loan, a 30-year option might appeal to you. This feature, called the Federal Consolidation Loan Program, provides the same three methods of payment described above, but over a longer term. The consolidation rate is fixed based on an average of the rates on the loans you have received plus 1/8 of a percent.

Using the $25,750 loan amount discussed above, let's illustrate the consolidation concept over four years. You borrow $25,750 each year at rates of 2%, 4%, 6%, and 8%, totaling 20%. The average rate, therefore, is 5% (20% divided by 4 years equals 5%). If you consolidate the four annual loans, the interest rate will be 5.125% (5 plus 1/8%), fixed for the term of the loan. The actual loan term is then based on the total amount owed, according to the following table:

So let's say that you owe $103,000 ($25,750 multiplied by 4) at the end of four years.Then your monthly loan payments would be $560.82, amortized over 30 years at 5.125%.

This illustration assumes you used the interest-only option--paying the interest during the four years of college and financing the $103,000 afterwards. Just like in the 10-year plan, you can also pay interest plus principal or elect forbearance. Plugging in the forbearance numbers from the 10-year plan would leave you a balance of $114,337 at 5.125% for 30 years. The payments would be $622.55 monthly. To further confuse the situation, you can elect the consolidation feature at any time during the four years of college.

Some lenders may offer incentives if you pay the consolidation loan on time. After 36 months of timely payment, the rate may be reduced by 1%. A rate of 5.125% thus would drop to 4.125%. If the lender is allowed to withdraw repayments directly from your account, an extra 0.25% discount may also apply, further reducing the rate to 3.875%.

Stafford loans are another option for financing college. These loans are given directly to students at more favorable rates than Parent Plus loans, but they have the same favorable term length. That is, a student can also elect to consolidate the loans at any time according to the table above. The trade-off is that the amount that a student can borrow is lower, of course. With Stafford loans, a student may borrow $2,625 in year one, $3,500 in year two, and $5,500 each in years three and four, for a total of $17,125.

The Stafford loan rate while the student is in school is based on the 91-day Treasury bill plus 1.7%. As of July 1, 2003, the 91-day T-bill rate was 1.12%, so the rate for the year was 2.82%. This rate is significantly better than the Parent Plus loan rate of 4.22% (91-day T-bill 1.12% plus 3.1% equals 4.22%). Based on the rate in effect as of July 1, 2003, the Stafford loan interest rate is capped at 8.25%. This cap changes every July 1 as the base rate also changes.

When paying off a Stafford loan, the student has the same three payment options as the parent has in Parent Plus:

• Interest and principal from inception over 10 years;
• Interest only (paid quarterly not monthly); or
• No payments until six months after school ends.

When the student starts making loan payments, interest is charged using a repayment index. That index is currently the 91-day T-bill rate as of July 1, 2003, plus 2.3%, or 3.42%. Assuming that the average Stafford loan rate is 2.82% as shown above, a 15-year loan of $17,125 at 2.82% would require a payment of $116.79 per month. However, the repayment index must be used during repayment. Since that rate is 3.42%, then the monthly payment is $121.75.

The Stafford loan that we have been discussing above, where interest is paid or added to principal if not paid during the school year, is an unsubsidized loan and not based on need. A subsidized Stafford loan, on the other hand, is based on need, and no interest is charged or needs to be repaid during school.

Stafford loans are enhanced when parents don't qualify for Parent Plus loans. In this case, students can borrow an additional $4,000 each in the first and second years, for a total loan of $6,625 and $7,500 in those two years, respectively. In the last two years, students can borrow an additional $5,000 per year. In those years, the total loan available is $10,500 per year. Over four years, therefore, a total of $35,625 is available to students in Stafford loans if their parents don't qualify for a Parent Plus loan.

Stafford loans are also available for a fifth undergraduate year if necessary. The maximum amount available with a Parent Plus loan is $5,500, plus an extra $5,000 if Parent Plus is not available. Over five years, therefore, students can borrow $45,625 in Stafford loans, assuming that their parents do not qualify for a Parent Plus loan.

In addition, graduate students can borrow $10,000 per year in unsubsidized Stafford loans. They may also qualify for an additional $8,500 per year in subsidized Stafford loans. Thus, the maximum an undergraduate and graduate student can borrow is $138,500.

Think that it's safe now for you to put your financial calculator down? Not so fast. There are many more options that your clients can use to get another day older and deeper in (college) debt.

For example, banks that are known as preferred lenders offer other types of college loans (as well as Parent Plus loans). My daughter's list of preferred lenders included eight banks, one of which was offering to lend $20,000 per year at prime rate with a 12-year term.

In addition, low-interest-rate federal Perkins loans are available from colleges and universities on a need-basis for both undergraduate and graduate students. Funds for Perkins loans come from the federal government and the borrower's college, and they must be repaid to the college, which is the lender.

Add in all the scholarship programs available, and the financing options are dizzying. As I found out personally, your clients will need all the help that they can get in negotiating their way through the college financing maze.

I'd tell you more about the subject, but I'm busy investigating a new loan program.The rate is tied to the S&P 500 and is hedged by cattle futures on the Chicago Board of Options Exchange. More on repayment choices later.

Michael J. Knight, CPA