Education Funding: Financial Aid and Student Loans

By Jessica L. Gibbs, CFP® | Aug 10, 2016 | Browse FAQ, Manage Multi-Generational Wealth, Weekly Market Commentary

Financial aid can help cover the costs of an undergraduate or graduate education. For some parents, federal and private loans provide an added benefit of having their child personally invested in their education. Navigating the options can be daunting, so the below information is intended to give you a preliminary overview of education financing options available to you and your child.

Free Application for Federal Student Aid (FAFSA)

Student aid is determined at the college level, but nearly all colleges begin the process with the FAFSA. The FAFSA determines financial aid eligibility by, in short, using a formula that identifies how much of a family’s resources ought to be available to assist in paying for a student’s education. Even if you think your family is too well-off to qualify for financial aid, it is still worth completing the FAFSA before your child heads to college. Just submitting a FAFSA qualifies your child for a low-cost, unsubsidized federal Direct Loan (formerly known as a Stafford Loan). It’s also a requirement for many other kinds of aid, including federal parent PLUS Loans, grants, work-study, and scholarships from state agencies, private foundations, and colleges. Here’s what you need to know before starting the application:

Determine income and assets

The application asks for both the parent’s and the student’s income and assets. While income is based on the amount reported on the prior year’s tax return, assets are counted as of the date you apply. This means you have time to manage your assets in order to maximize your financial aid eligibility. Your IRAs, retirement plans, and primary residence are not counted towards your net worth, so do not include these accounts as part of your assets.

Who owns an asset impacts aid eligibility

Any money you’ve contributed to accounts owned by the child—such as in an UGMA or UTMA—reduces the need-based aid they’re eligible for by 20%, while funds in accounts you own—including 529 accounts—reduce aid by 5.6%. 529 accounts owned by grandparents are not reported as an asset on the FAFSA, but any funds taken from these accounts to pay for qualified education expenses will be reported as income on subsequent FAFSA applications, so it is best to reserve these funds for later college years.

File your FAFSA sooner rather than later

Because some aid is awarded on a first-come, first-served basis, it is beneficial to file the FAFSA early. Research has indicated that families who file before March 30 typically get more than twice as much aid as those who file later.

Changes to the FAFSA

Forthcoming changes to the FAFSA will simplify the form and allow you to submit your application earlier. You will be able to file a 2017-2018 FAFSA as early as October 1, 2016, rather than beginning on January 1, 2017. This adjustment to the application period start date means the FAFSA will use income information from earlier years. For example, you and your child will report income from 2015 for the 2017-2018 FAFSA.

Federal Financial Aid Programs

The U.S. Department of Education has several financial assistance programs available to students and their parents.

Direct Subsidized and Unsubsidized Loans

Direct Loans (formerly known as Stafford Loans) are the primary type of financial aid provided by the Department of Education. The loans are either subsidized or unsubsidized. Subsidized loans are based on the financial need of the student as determined by the FAFSA and charge no interest until repayment of the loan begins. Unsubsidized loans charge the borrower interest on the principal from the moment of disbursement until the loan is paid off. Repayment of Direct Loans begins after a grace period of six months following graduation, leaving school, or dropping below half-time enrollment. The interest rate for the 2015-2016 academic year is 4.29% for both subsidized and unsubsidized loans. Loans are subject to an additional fee (1.068% for the 2015-2016 academic year) on each loan disbursement.

There are limits on the amount of subsidized and unsubsidized loans students are eligible to receive each academic year. The annual loan limit for first-year students is $5,500; $6,500 for second-year students; and $7,500 for third-year students and beyond (if the student is claimed as a dependent). Additionally, dependent students may borrow no more than $31,000 in aggregate from federal student loans.

Parent Loans for Undergraduate Students (PLUS Loans)

PLUS Loans allow parents with good credit histories to borrow funds up to the cost of a child’s education expenses (less any other available financial aid). Funds are disbursed in at least two installments, and parents must begin repaying the loan within 60 days after the final loan disbursement for the current academic year. Consequently, parents must often begin repaying principal and interest while the student is still in school. PLUS Loans generally must be repaid within 10 years. The interest rate for the 2015-2016 academic year is 6.84%. Interest accrues on the loan from the moment of disbursement until the loan is paid off. Loans are subject to an additional fee (4.272% for the 2015-2016 academic year) on each loan disbursement. Due to the higher interest rate and loan fee, it is better to obtain a Direct Loan rather than a PLUS Loan, even if the parent intends to pay the debt.

Direct Consolidation Loan

Direct Consolidation Loans provide borrowers with a vehicle to consolidate various types of federal student loans with separate repayment schedules into one loan. They can benefit both students and parents by extending the term of repayment, requiring only one payment per month, and in some cases providing a lower interest rate than on one or more of the loans. However, be sure to compare all terms before consolidating.

Federal Pell Grant

Pell Grants are awarded to low-income undergraduate students and do not require repayment.

Federal Flexible Repayment and Loan Forgiveness Programs

A federal Direct Consolidation Loan can make a borrower eligible for several flexible repayment programs only available for federal loans.

Income – Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE) Programs

The IBR, PAYE and REPAYE programs cap loan repayments at 10% of the borrower’s discretionary income. Any remaining balance is forgiven after 20 years. Any loan balances that are forgiven are taxable income to the borrower at that time. In order to qualify for the IBR and PAYE programs, the borrower must have a partial financial hardship.

Public Service Loan Forgiveness (PSLF) Program

The PSLF program forgives the remaining federal loan balance after the borrower has made 10 years of payments under a qualifying repayment plan while working full-time for a government agency, non-profit organization, AmeriCorps or the Peace Corps. It can be applied in addition to the IBR, PAYE or REPAYE programs. Unlike IBR, PAYE and REPAYE, forgiven loan balances are not taxable to the borrower.

Private Student Loans

Unlike federal student loans, private loans are not sponsored or guaranteed by government agencies and do not require completion of the FAFSA to qualify. Private loan eligibility requirements, interest rates and terms vary from lender to lender. In most cases, students should only consider obtaining a private education loan after they have maxed out the federal Direct Loan.

Interest rates are based on credit history

Private loans can have variable interest rates, which may substantially increase the total amount you or your child repays. Lower rates and fees are only available to borrowers with good credit who also have a creditworthy cosigner.

Complete terms and rat es are not advertised

Lenders rarely give complete details of the terms of a private student loan until after the student submits an application, in part because this helps prevent comparisons based on cost. It is not uncommon for lenders to only advertise their lowest interest rates and fees, which are only available to borrowers with good credit or while the student is in school. Higher rates can take effect when the loan enters the repayment period after the student graduates.

Federal and private loans should not be consolidated together

Private loans can be consolidated, which resets the term of the loan and may result in a reduced monthly payment. Additionally, you or your child may be able to get a lower interest rate through a private consolidation loan if your credit score has improved significantly since you first obtained the loan. Private loans, however, should not be consolidated with federal loans. Doing so causes the borrower to lose access to the flexible repayment and potential forgiveness programs offered on federal loans.

Avoid making late payments

Making late payments can be reported to all consumer credit reporting agencies, which can make it more difficult or more expensive to obtain future credit for additional student loans, auto loans, mortgages or credit cards.

Tax Credits and Deductions

There are several income tax credits and deductions that you or your child may be eligible for in order to reduce your or your child’s tax liability.

American Opportunity Tax Credit (AOTC)

The AOTC offers a maximum annual credit of $2,500 per student for the first four years of college. It can be claimed by parents paying for their child’s undergraduate degree, or by working students paying their own way through school. The credit can be applied to tuition, fees, books and supplies. To get the full credit, the taxpayer must make less than $80,000 if filing single or $160,000 if married filing jointly. If you have 529 accounts and are eligible for this credit, you will want to pay $2,500 for tuition out of pocket in order to receive the credit, rather than fully paying tuition from the 529.

Lifetime Learning Credit

This tax credit is available towards the cost of tuition and fees for undergraduate, graduate and professional degree programs, up to $2,000 per year for the entire household. The credit can be claimed an unlimited number of times, but not in conjunction with the AOTC. To claim the credit, the taxpayer must make less than $65,000 if filing single or $130,000 if married filing jointly.

Tuition and Fees Deduction

This deduction lets you use up to $4,000 of expenses for tuition, fees, books, equipment and supplies to lower your taxable income. This deduction is claimed as an adjustment to income, which means you do not need to itemize your deductions to take advantage of this. To be eligible, the taxpayer must make less than $80,000 if filing single or $160,000 if married filing jointly and cannot by claimed as a dependent on another person’s taxes.

Student Loan Interest Deduction

Students paying interest on their education loan debt may be eligible for a deduction equal to the lesser of $2,500 or the amount of interest actually paid. As with the Tuition and Fees Deduction, your child does not need to itemize your deductions to get the Student Loan Interest Deduction, but they cannot be claimed as a dependent. To take advantage of the deduction, the student must make less than $80,000 if filing single or $160,000 if married filing jointly.

Sources for Additional Information

The following websites are good starting points for additional information on college funding programs and costs:

• www.StudentAid.ed.gov
• www.SavingforCollege.com
• www.FAFSA.ed.gov
• www.FinAid.org
• www.EFCPlus.com
• www.CollegeAbacus.org