When the time comes to pay for your child’s college education, you will most likely need to borrow some money for expenses. Even if you do have the savings available to pay for the entire cost of a college education, there are some benefits in taking out a loan that you may want to consider.
Some reasons to consider taking out a loan for college costs:
1) Continue to grow your current investments.
If you tap into an investment that is earning significant interest, you will be losing that earning potential and paying the cost it takes to sell the investments, such as transfer fees, income taxes and capital gains tax. Instead, consider taking out a low interest loan.
2) Teach your children financial responsibility.
Your child may take their education more seriously if they have personal investment involved. Seeing the dollar value on a loan in their name could help your child become more responsible with his or her budget, education, and career.
3) Tax benefits.
Congress passed the Taxpayer Relief Act of 1997 in an effort to make college more affordable. The Tax Reform Act of 1997 allows college loan interest to be deductible, within certain income phase-out limits.
Types of Loans to consider:
Federal and state governments, colleges, and private organizations provide college loans to parents and students. The following is an overview of your options:
Need-Based Loans
- Federal Perkins Loans
- May be awarded by colleges to students with the highest need.
- Your school is the lender.
- There is no interest while in school.
- The interest rate for a Perkins loan is a fixed 5%.
- Federal Direct Subsidized Loans
- The Federal Government pays the interest while you are in school.
- Your school determines the amount you can borrow.
- The interest rate is a fixed 3.76%.
Non-Need-Based Loans
- Federal Direct Unsubsidized Loans
- Your school determines the amount you can borrow.
- You will be charged interest, but you can add the interest fees to the amount you borrow until after graduation (this will mean you will end up paying more money over time).
- The interest rate is a fixed 3.76% for undergraduate and 5.31% for graduate or professional schools and starts accruing as soon as the loan is taken out.
- Federal Direct PLUS Loans
- Allows parents or graduate students to borrow the total cost of college, minus any financial aid received.
- Interest accrues while in school.
- The interest rate is a fixed 6.31%.
Private Loans (Alternative Education Loans)
- Provided by private lenders and does not use government funding.
- Your eligibility and interest rate depends on your credit history.
- Terms and rates for borrowing vary by lender and often require a cosigner.
State Loans
To see what college loans may be available from your state, visit College Scholarships.org.
Personal Residence Loans
- Home equity line of credit
- You can borrow only the amount of money that is needed, so you will pay interest on only the amount borrowed.
- The interest charged is variable.
- Home Equity Loan (Fixed Rate Loan)
- This is a closed end or fixed rate 2nd mortgage loan.
- Rates tend to be higher than 1st mortgage loan.
Another option is to refinance your mortgage for a lower interest rate to increase your cash flow. Once your child graduates, if there is any money left over, you can use it to pay down your remaining mortgage.
Borrowing from a retirement account
In general, it is not advised to borrow from your retirement account to pay for college expenses. Even though funds from a retirement plan loan for college education are not subject to the 10% early withdrawal penalty or income tax, there are many downfalls to borrowing money this way, such as:
- The loan must be repaid in five years.
- If you quit, are fired, or are laid off, your loan may be due immediately.
- You are losing the money your retirement funds would have been generating through earnings and compounding.
- If you are unable to repay the loan, the remaining balance owed will be considered a taxable distribution and there will be a 10% early withdrawal penalty if you aren't 55 1/2 or older. There may also be state tax penalties.
You may also want to consider consolidating your existing loans. This could help lower your monthly payments and increase your cash flow.
If you decide to take out a loan, it is important to shop around to compare interest rates, fees, and repayment options, and be sure to understand a loan’s terms and conditions in order to borrow wisely.
Carol Chaudet
Last Updated: 3/22/2017