Day 43 (PF)

Student Loan

(CW10B)

Introduction

Reading Material

Student Loans

If you are a student who has a student loan or will take one out before you leave school, you are not alone.   According to The Federal Reserve, upwards of 50% of young adults (age 18-29) have taken out some type of education debt to pay for a college degree. The most common type of education debt incurred is student loan debt followed by credit card debt and home equity loans. The amount of debt students take on is influenced by a variety of factors starting with the college or vocational school attended, scholarships and grants awarded and Expected Family Contribution (EFC). If a student loan is needed the first step is to research the types of loans available.  Equally, if not more important is to research and understand the financial ramifications of each type of loan as it relates to repayment as there are only a few scenarios that result in student loan forgiveness.

Direct Federal Student Loan

Direct loans are funded by the federal government with the limits being based on the year in school (1st year, 2nd year, etc.) and whether a dependent or independent student.  In order to be eligible for any type of federal financial aid, including a student loan, applicants must complete the Free Application for Federal Aid (FAFSA).  The FAFSA application period begins October 1. The filing deadline for the FAFSA is February 15 but since the deadlines of some individual colleges and states are earlier, it is advantageous to file the FAFSA as early as possible.  For assistance with filling out the FAFSA go to the free government website: Completing the FAFSA.

Types of Federal Student Loans

There are three types of federal Direct Student Loans: Stafford Loans, Consolidation Loans, and PLUS Loans.  The most common is the Stafford. All have a fixed interest rate and are available to undergraduate students.  To be eligible for any Direct Student Loans one must be a U.S. citizen or an eligible non-citizen and enrolled at least half-time in an eligible degree or certificate program at a college or career school.

Direct Stafford Loans

Subsidized vs. Unsubsidized

The most common Direct Student Loan is the Stafford which has two types, subsidized and unsubsidized.  The subsidized loan is need-based and available to only undergraduate students, while the unsubsidized is not based on need and available to both undergraduate and graduate students.  Direct subsidized and unsubsidized student loans by default have a fixed monthly payment for a 10-year loan term with a 6-month grace period, meaning payments are not required until six months after graduation, dropping out or dropping below half-time status.  The key difference between the two loans is the federal government pays the interest on subsidized loans while during school, during the grace period, and during deferment, a period of time when loan payments are not required.  This could save the borrower thousands of dollars.  To see this in action let’s compare a $25,000 subsidized student loan to an unsubsidized loan of the same amount.

The subsidized loan accrued total interest of $9,078.85 ($6,019.45 + $3,059.40), but the borrower is only responsible for $6,019.45 because the government subsidized the loan; meaning it paid the $3,059.40 of interest while the borrower was in school and during the grace period.

Even though both loans have the same interest rate and have the same payback period* the unsubsidized loan will cost $4,075.24 ($10,094.69 – $6,019.45) more in interest over the course of the loan.  This is because the interest that accrued during school and during the 6-month grace period ($3,284.65) is paid by the borrower, not the federal government.  The additional $790.59 ($4,075.24-$3,284.65) is due to compounding on the accrued interest.

Consolidation Loans

Student loans will usually cover a full academic year and the school will pay out the money at least once per term (semester, trimester, or quarter).  The loan will not begin accruing interest until the funds are paid out.  As a result, by the time some students finish school, they could have 8-10 different student loans with different payment amounts, due at different times of the month to different loan servicers.

This can be confusing and difficult to manage for the borrower.  For this reason, a Direct Consolidation Loan may be a good financial decision.  This loan allows the borrower to combine multiple federal education loans into one loan, resulting in a single monthly payment to one loan servicer.  In addition, Direct Consolidation Loans can also provide the borrower with access to additional loan repayment plans and forgiveness programs. The timing of consolidating matters.  Consolidating loans during the grace period will result in forfeiting the remainder of the grace period. This could result in having to pay more total interest than waiting until after the grace period ends.

PLUS Loans

Parents of eligible dependent undergraduate students who need money for education beyond their financial aid award can apply for a Parent PLUS Loan. Graduate students seeking funds can apply for a Grad Plus loan. PLUS loans are not based on financial need and are limited to the total cost of attendance at the student’s school, minus all other aid. PLUS loans have a fixed interest rate that is higher than the interest rate of Stafford loans and require a credit check and possibly a co-signer. Unlike Direct Stafford loans, PLUS loans do not have a grace period.

Loan Disbursement

Students offered a Direct Loan in their financial aid package can accept a portion of the loan, all of the loan, or decline the loan altogether.  If the loan is accepted, schools typically apply the funds first to tuition, then fees, and then room and board.  All Direct subsidized and Direct unsubsidized Federal loans charge a loan origination fee (percentage of the total loan amount) when the loan is first disbursed.  Loans can be canceled without a fee or interest within the first 120 days.  This fee is deducted from the loan amount you receive. As a result, loan proceeds are less than the amount you actually borrow (loan origination fee gap).  This should be taken into account when determining the loan amount.  Students receiving a federal student loan are required to complete entrance counseling and sign a Master Promissory Note (MPN).   For free student loan assistance go to studentaid.ed.gov or call 1-800-4-FED-AID.

Student Loan Repayment

As the time for repayment of the student loan nears the borrower will be offered several repayment options. If the borrower does not choose a plan, they will be placed on the Standard Repayment Plan, which will have the loan paid off in ten years. Changes to the repayment plan can be made at any time with no fee.

The grace period is intended to provide the borrower time to find a job and begin earning income before having to start repaying their loans. Regardless whether graduated or employed, the borrower will be expected to begin repayment when the grace period ends.  There is no grace period for Consolidation and PLUS loans.

There are no penalties for paying off a federal student loan early, so the borrower can start making payments early (while you are still in school and/or during the grace period).  If student loan debt is the highest rate of debt a borrower has, it may make sense to prepay the loan. Paying even a little bit each month during this time period will reduce the total amount owed.

Loans can be paid off faster by requesting the extra funds go toward the loan principal and not future payments.  Paying off the loan earlier and reduce the amount paid in interest over the life of the loan.

Sheridan has a subsidized federal student loan and pays $100 dollars extra a month allowing her to save 8% of the total loan amount.  Increasing the extra payment to $200 results in a 12%, or over $3,000 savings.

Lavinia has an unsubsidized federal student loan and pays $100 dollars extra a month allowing her to save 9% of the total loan amount.  Increasing the extra payment to $200 results in a 13%, or over $3,000 savings. 

Like other monthly payments, a student loan bill is due even if the borrower does not receive it.  Signing up for automatic payment with the loan provider will prevent missing a payment and result in a 0.25% reduction in the loan interest rate. This will save money by lowering interest and avoiding late or missed payment fees.

Repayment Options

Federal Student Loans provide a variety of repayment options that private student loan lenders may not.  Private student loans may or may not have a grace period.  There are specific student loans that are eligible for deferment or forbearance.  It is rare that a student loan would be discharged even in bankruptcy.  The federal government provides a Repayment Estimator providing you the ability to compare estimated monthly payment amounts for all federal student loan repayment plans.

Graduated Repayment Plan

If a borrower’s income is expected to increase significantly over the years, a graduated repayment plan should be considered. This establishes a lower monthly payment at first, with payments increasing over time, as income increases.  With a graduated repayment plan, the lower monthly payment will never be less than the monthly interest due, so the principal of the loan should not increase.

Income-based Repayment (IBR) Plans

Borrowers whose student loan debt is a significant portion of their income may want to consider this type of plan because it is based on income rather than the amount of debt owed. Payment amounts are re-evaluated each year based on current income.  The plan is available to undergraduate and graduate students and is eligible for loan forgiveness after 20 – 25 years, depending on when the money was borrowed.  IRS rules do require taxes be paid on the amount forgiven.

The salary for Carol’s first job out of college is $25,000 and her student loan debt is $37,172.  Her monthly payment without IBR is $406, with IBR her monthly payment is $86 a month.  

This helps Carol’s monthly budget, however paying less each month extends the life of the loan resulting in more interest paid over the life of the loan.  In addition, the low monthly payment may not cover the cost of the interest due, resulting in the unpaid interest increasing the principal balance.  For details on the different income-based repayment plans available visit studentaid.ed.gov.

Delinquency and Default on a Federal Student Loan

Delinquencies and defaults on student loans are reported to the credit bureaus, resulting in the borrower’s credit rating and future borrowing ability being negatively impacted.  Delinquency (missed payments) will result in a late fee assessed. After 90 days a delinquent federal student loan will be reported to the three major credit bureaus.  Private loan servicers may report earlier. Delinquencies have a negative impact on credit scores and the ability to get a credit card or loan. A delinquency can affect future interest rates and the resulting drop in the borrower’s credit score can trigger higher interest rates on existing credit cards.

When a student loan goes unpaid for at least 270 days (9 months) the loan is considered in default. At this point, the federal government may instruct the borrower’s employer to withhold a portion of pay (up to 15%) to repay the defaulted loan.  This is called a garnishment and can also be applied to Social Security benefits (at 15%) and tax refunds. They may also decrease any loan payment by 25 % to pay collection fees, reducing the amount that actually goes to repaying the loan.  This increases the duration of the loan thereby increasing the total amount of interest paid.

Missing student loan payments or default on a student loan has serious financial consequences. Remember that federal student loans have different repayment plans which can be changed at no cost. If having difficulty paying a private student loan, contact the loan servicer to review your loan to see if there are other options available instead of default.

Student loan debt and your credit score

Student loans are not included in the credit utilization portion of the credit score, however, that does not prevent them from indirectly impacting your credit score as a result of poor money management.
Trinity is a finance student who during four years of college received scholarship money, but still had the need for a student loan. Upon graduation, her student loan debt was $115,000. Six months after graduation the first student loan bill for $825 arrived. Without enough money to make the payment she charged the $825 on her credit card, truly intending to be able to pay it off the following month.  Six months later, Trinity has accumulated $6,000 in credit card debt increasing her credit utilization rate to 80%.  As a result, the variable interest rate on her credit card rises increasing her payments and her debt.

Private Student Loans

The federal government is not your only option for a student loan, you can also obtain a loan from a bank.  However, there are financial advantages of a federal loan when compared to private student loans.


It is important to recognize that private loans often have a variable interest rate, meaning the monthly payment can increase over time.
Private student loans have higher interest rates than federal student loans.  To compare a subsidized, unsubsidized and private loan in this example we are assuming a fixed interest rate of 7.25% for the private loan. In this example, the result is payments totaling approximately $43,113 which is approximately $18,113 more than the original loan amount of $25,000 disbursed to pay tuition and leads to a much higher monthly payment of $359.28.

It is important for students to fully understand their options before accepting student loans. There are significant differences between subsidized and unsubsidized and federal and private loan programs. Knowing these differences will help students make financially sound decisions. There are also decisions to be made once schooling is finished. Deferment, consolidation, prepayment, and forgiveness are all possibilities that must be considered and re-evaluated during the life of the loan.

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