Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

New data shows that student loan growth has slowed in the past several years. And although that sounds good, there is more to the story.

Student loan balances have hit a plateau in recent years, but it is not because college costs are dropping or fewer students are going to college. Rather, it is because parents are increasingly taking on student debt themselves, says Mark Kantrowitz, publisher and vice president of research at Savingforcollege.com.1

But it is not necessarily because parents want to shelter their kids from taking on loans. In many cases, it is because student loans will not cover the full cost of college. Federal student loan maximums have not been updated for a decade and therefore have not kept pace with increasing college costs. Dependent students cannot have more than $31,000 in federal loans in total, and no more than $23,000 of this can be in subsidized loans. This maximum nearly doubles for nondependent undergraduate students ($57,500), and jumps to $138,500 for graduate and professional students ($224,000 for medical school students).

Kantrowitz found that student loan growth has continued to rise among the latter two populations with higher aggregate federal loan limits. By contrast, the average student loan balance for dependent students has been hovering right at the $31,000 limit for years.

What Does This Mean for Parents?
Parents, particularly of those students attending more expensive colleges, have increasingly taken out loans. According to Kantrowitz, parent debt increased significantly for middle- and high-income students (33.4% and 20.2%, respectively), who tend to attend higher cost colleges, but not as much for low-income students (3.2%), who tend to enroll in schools with a lower cost of attendance.

If your student has maxed out Direct subsidized and unsubsidized loans (which have low fixed interest rates of 5%) and you need to borrow to make up the difference, we will compare the Parent PLUS loan with some other loan sources.

One thing to keep in mind is the impact certain funding sources have on the expected family contribution, which is calculated based on information reported on the Free Application for Federal Student Aid. To maximize aid, you will want to keep this number as low as possible. Avoid funding sources that would be considered income until after you have filed your second-year FAFSA. Parent income is counted at 22%-47% on the FAFSA and is reported using prior-prior-year tax information (for the 2018-19 tax year, parents report income from their 2016 tax return).

Parent PLUS Loan
A federal Parent PLUS Loan for undergraduate students is available through the Department of Education. You can borrow up to the cost of attendance minus other aid. The interest rate is fixed, currently 7.6% (plus an origination fee) for the 2018-19 school year. You can deduct up to a maximum of $2,500 interest paid for the PLUS loan. This loan has flexible repayment options, and the debt is discharged in the event of disability of the borrower or death of the borrower or student.

The downsides: Parent must not have an adverse credit history. If a parent has an excellent credit rating, a private student loan may have lower interest rates (though always read the terms and conditions; know whether the interest rate is fixed or variable.)

Impact of this funding source on financial aid: None.

Home Equity Line of Credit
Especially if you have good credit, the interest rates on home equity lines of credit can be competitive compared with the federal Plus Loan, which is 7.6% (plus an origination fee of 4.25%) for the 2018-19 school year.

The downsides: The loan collateral is your house. That means that if you default on your loan payments, you home could be repossessed. The interest paid on home equity loans is no longer deductible under the Tax Cuts and Jobs Act of 2017. (Many people have heard that this deduction is alive and well, but the deduction is only allowed if the loan is used to buy, build, or substantially improve the home that secured the loan. College funding does not qualify.) In contrast, you can deduct interest paid up to a maximum of $2,500 for the PLUS loan.

Impact of this funding source on financial aid: Your home equity is not reported as an asset on the FAFSA. It is better to use a home equity line of credit than a home equity loan so you can rightsize the withdrawal; any unspent money from a home equity loan counts in the EFC calculation.

Roth IRA
Roth IRA contributions can be withdrawn tax-free for any purpose. And while you will typically face taxes and a 10% early withdrawal penalty if you take out investment earnings from your Roth before age 59 1/2, the 10% penalty usually assessed for early withdrawals from an IRA is waived if funds are used to pay for college tuition, books, fees, and other qualified expenses.

The downsides: The yearly contribution amounts for a Roth IRA are much smaller than for a 401(k) or 529, at $6,000 for those younger than 50 and $7,000 for those older than 50. If you were depending on the Roth IRA to help fund your retirement, using it to fund college costs could seriously deplete your savings. Even if you plan to pay it back, you are depriving yourself of years of tax-free growth and distributions.

Impact of this funding source on financial aid: Wait until after second-year FAFSA is filed. Parents’ retirement accounts are not counted in the financial aid calculation unless you take a withdrawal from them to pay for college. Then they are counted as income in terms of the expected family contribution.

Life Insurance
Cash-value life insurance policies pay a death benefit, and if you start investing in them early enough, by the time your kids are ready to leave the nest you could have a substantial cash balance to borrow against.

The downsides: Cash-value life insurance policies can be expensive and investment returns are often low. In addition, interest is charged on the loan from the cash balance (and you do not pay it to yourself, as with 401(k) loans). If you take a withdrawal that exceeds the amount you have contributed, you will owe income tax on the earnings distributed.

Impact of this funding source on financial aid: Wait until after second-year FAFSA is filed. The cash value of a life insurance policy is not reported as an asset on the FAFSA.

However, distributions from a cash-value life insurance policy are counted as income in terms of the expected family contribution.

401(k) Loan
You repay 401(k) loans with interest, but you pay the interest to yourself. You must make periodic payments and the entire loan balance needs to be repaid within five years.

The downsides: If you leave your employer before the loan is repaid you will be taxed at ordinary income tax rates on the loan amount, and you will also pay a 10% penalty. Also, even if you pay the loan back as planned, the opportunity cost of keeping that money on the sidelines could be big.

Impact of this funding source on financial aid: Wait until after second-year FAFSA is filed. Parents’ retirement accounts are not counted in the financial aid calculation unless you take a withdrawal from them to pay for college. Then they are counted as income in terms of the expected family contribution.

529 College-Savings Plan
If you are in the position of having to borrow to fund your child’s college expenses this advice is too little, too late. But if you still have time, let compounded interest work for you and not against you by setting up an investment account as early as possible.

529s are funded with aftertax contributions (you cannot deduct them from your federal income tax), but contributions may receive a state tax break (either a deduction or a credit). Money compounds on a tax-free basis and withdrawals to pay for qualified college expenses are tax-free, too. Each person (a parent, a grandparent, etc.) can contribute up to $15,000 annual gift-tax exclusion, or $30,000 per married couple.

The downsides: Limited investment options. Research is required: Fees can be high, and asset allocations and glide paths vary by administrator.

Impact of this funding source on financial aid: 529 accounts are considered a parent asset on the FAFSA and are counted at 5.64%. Qualified 529 plan distributions are not counted as income on the FAFSA.

 

© Morningstar 2018. All Rights Reserved. Used with permission.

1. Growth in student loan debt at graduation slows as borrowers hit loan limits, https://www.savingforcollege.com/article/growth-in-student-loan-debt-at-graduation-slows-as-borrowers-hit-loan-limits