Student loan arrangements can have unforeseen, long-lasting implications for a family's financial future. To illustrate this point, let's look at a nightmare scenario that is based on a real-life situation.
A few months before his eagerly anticipated early retirement, 62-year-old Tom was diagnosed with a terminal disease. Most patients with this disease live two to five years from the date of the diagnosis.
Tom was always careful planning his family's finances. He prepared a monthly budget and began planning for an early retirement with his wife, Jo, when he was in his early 30s. His four children all went to college, which the family financed primarily through private student loans.
But Tom missed a crucial detail included in the promissory note. If the student or the co-signer died before the loans were fully paid, the loans became immediately due. At the time of his diagnosis, the loans due totaled almost $150,000.
Tom and Jo were devastated by the news. Tom was already worried that too much would be spent on his care, leaving less for Jo, who was just 60, to live on after his death. Jo was concerned with making Tom as comfortable as possible during the time he had left, no matter the cost. Thinking that $150,000 would now have to be diverted from the insurance proceeds at Tom's death only increased their fears.
What you need to know about student loans
This story illustrates what can happen when borrowers do not realize the full implications of the loans they have taken out. Of course, not all repayment situations will be so dramatic. But Tom and Jo's story underscores the importance of knowing the basics about undergraduate student loans. Here are some of the most important things you need to know before you or your children take out a student loan:
- There are two types of student loans. Federal student loans (FSLs) are issued directly to students by the federal government. Private student loans are issued by banks or other financial institutions.
- FSL interest rates are either subsidized or unsubsidized. Subsidized FSLs do not accrue interest while the student is in school. Unsubsidized FSLs accrue interest while the student remains in school.
- FSLs and private loans have different repayment terms. The repayment terms for FSLs are more flexible and offer relief if needed. Private student loan terms are set by the lender and offer little flexibility or relief if the student has trouble repaying the loan.
- FSLs are based on a student's financial need, not on the borrower's (or parents') credit rating. The only exception among FSLs is the parent PLUS loan. Financial need is calculated as the difference between the cost of attending a school and the student's expected family contribution.
These four points are certainly not exhaustive. But they are a good place to start as you or your clients consider student loan options.
Below are some tips to keep in mind when you're considering financing college with student loans:
- FSLs are typically better for the student for various reasons. The interest rate on an FSL is often lower than a private student loan. (However, private student loans can have lower interest rates if both the student and co-signer have excellent credit.) Also, repayment terms for FSLs are more flexible and offer relief if needed, whereas private student loans' terms are set by the lender and are generally less flexible. Even if a student's or a parent's employer offers special access to private student loans, check out the availability of FSLs before opting for a private student loan.
- While in school, students should consider paying off the interest accruing on an unsubsidized loan to minimize the overall interest they'll need to pay on the debt.
- Students do not need to borrow all the money available. If possible, students should borrow only what they need to cover tuition, books, and fees, and pay living expenses with income earned by working part time or applying for a work/study program as part of the Free Application for Federal Student Aid (FAFSA) form.
- When applying for a private student loan, ask questions of the lender, read the terms very carefully, and, more importantly, read the promissory note! Consult a CPA or an attorney if you are unclear about the terms.
- Whether a student applies for an FSL or a private student loan, he or she should plan the loan backward. In other words, students should think ahead to the loan repayment. What are their job prospects given their major and degree? What will they earn right out of school? High student loan debt—whether for an FSL or a private loan—can limit the choices a student has when he or she looks for a job. A recent graduate may even have to move back in with Mom and Dad until his or her student loans are paid off.
That's why students should have a realistic idea of what the amount of their monthly loan repayment will be. This information can help them make more informed decisions about how they want to finance their college education and, in some cases, which major they elect.
Many nonprofit credit counseling agencies now provide student loan counseling services. Finding a local agency that is a member of the National Foundation for Credit Counseling or the Financial Counseling Association of America is a good place to start.
AICPA PFP/PFS members have access to additional education planning content through Forefield Advisor at aicpa.org/pfp/forefield.
James Sullivan, CPA/PFS, is a board member of Consumer Debt Counselors Inc., a not-for-profit debt counseling agency. Melissa Towell is a student loan counselor for Consumer Debt Counselors Inc. To comment on this article, email Chris Baysden, senior manager of newsletters at the AICPA.