The credit crisis that began with the collapse of the sub-prime mortgage market in 2007 has sent reverberations through U.S. financial markets. And, as many students and their parents know, the college loan market has not been immune to the effects.
Market turmoil has made many private lenders reluctant or unable to finance student loans. For some lenders, the College Cost Reduction and Access Act, passed in 2007, made the loans less profitable. For others, young borrowers with limited credit history pose too large a risk. The net result: Many lenders have opted to become dropouts of the college loan business.
Still, the fact remains that most students require some type of financing to cover the climbing cost of attending college. According to The College Board, published college prices are rising more rapidly than the cost of other goods and services—a phenomenon recorded over the past 30 years. Combine the decades-old reality of rising college costs with the modern-day concern about shrinking loan options, and it is clear why many students and parents may be concerned about how they will pay the tuition bills.
Following is a look at current college loan options and the impact the credit crisis has had on each.
Student Loans Options
Federal student loans are guaranteed by the U.S. government and are available to every student regardless of income or credit rating. The two primary types of federal student loans are Stafford loans and Perkins loans.
Stafford loans are borrowed in the student’s name and available to all regardless of income. However, students must meet certain eligibility requirements and are subject to a cumulative maximum loan amount over four years. Stafford loans are offered at a fixed interest rate of 6.8% or less; low-income borrowers can receive a lower interest rate. There are two categories of Stafford loans:
- Federal Family Education Loan (FFEL) Program: These loans are provided by private lenders (e.g., banks, credit unions) and are guaranteed against default by the federal government.
- Federal Direct Student Loan (FDSL) Program: These loans are provided by the government directly to students and parents via “direct-lending” schools.
Stafford loans come either subsidized, meaning the government pays the interest while the student is in school, or unsubsidized, whereby the student pays all of the interest (but may defer the payments until after graduation). Eligibility for subsidized loans is based on financial need.
Perkins loans are awarded based on exceptional financial need. This program is school-based, with the college acting as the lender using a pool of funds provided by the government. The interest on the loan (a fixed 5%) is paid by the federal government while the borrower is in school, and for a nine-month grace period thereafter.
The federal loan program for parents of dependent students is the Parents Loans for Undergraduate Students (PLUS) program. Like the Stafford program, PLUS loans are either provided by private lenders (an FFEL PLUS loan) or directly by the government (a Direct PLUS loan). Unlike the Stafford loan, however, there is no cumulative limit on PLUS loans. Parents can borrow up to the full cost of attendance (less any financial aid awards). While PLUS loans have larger limits, they also have higher interest rates than the student loan program (fixed at 8.5% or less, depending on the program) and borrowers are subject to credit approval.
Private loans are offered by independent lenders with no government endorsement, intervention or oversight. They tend to be more expensive than the government sponsored education loan programs, but historically have offered more flexible pay-off parameters and higher limits. Borrowers are subject to credit approval, and interest rates are generally based on the borrower’s credit score. According to The College Board, private loans constitute a growing share of education borrowing. (See chart below.)
Availability of Student Loans
In May 2008, the U.S. government passed legislation to help ensure funds are available for college-bound Americans. As such, the federal student loan programs are the least altered by the credit crisis. The FDSL program (the direct-lending version of the Stafford program) and the Perkins program are fully funded by the government and have weathered the crisis relatively well.
That said, several lenders have left the FFEL, the Stafford program that relies on the participation of private lenders. Fortunately, the largest lender, Sallie Mae, continues to participate and partner with the government in finding solutions to the college loan scare. In fact, Congress worked quickly this year to pass the aforementioned legislation aimed at forestalling a significant college loan crisis. Since the law’s ratification in May, several lenders that had left the FFEL program have returned, attracted by the government’s new lender subsidies.
The legislation comes with other provisions as well. The Department of Education was given the authority to increase the number of schools that participate in the FDSL (the direct-lending program) and has doubled that program’s capacity since the legislation was signed. The law also raised the maximum on unsubsidized Stafford loans by $2,000 annually. The government’s goal is to augment the federal student loan program, attract lenders and enhance options for college bound borrowers amid dwindling private loan choices.
Parent loans, both the Direct PLUS and FFEL PLUS versions, may be harder to come by given the fact that parents are subject to credit approval. But FFEL PLUS loans, because they involve the participation of private lenders in addition to requiring a credit check, are more difficult to secure as lenders tighten their standards and offer funds only to the safest borrowers. The good news is that if a parent is denied a PLUS loan, the student is eligible to have his or her Stafford loan amount doubled.
Finally, private loans are becoming the most difficult to secure. As mentioned earlier, the turmoil in the credit markets has caused many private lenders to abandon the college loan business, either because these loans are not profitable or the risk is simply too high at this point in the market cycle. Those that remain have tightened their lending standards and raised interest rates.
The bottom line: Federal student and parent loan programs continue to benefit from government support. Private loans to subsidize these forms of college financing are the most difficult to come by in the current environment. The government has passed legislation to enhance the Stafford student loan program to pick up some of the slack. Where this pales, borrowers will need to be diligent in their search for a loan, carefully evaluating terms and interest rates offered.
Planning Ahead: as Easy as 5-2-9
A parent (or any adult) can establish a 529 account on behalf of a student to cover qualified education expenses. Earnings on and withdrawals from a 529 account are exempt from federal, and sometimes state, income tax as long as the money is used for eligible college expenses. (Withdrawals not used for eligible college expenses may be subject to income tax and an additional federal penalty tax.)
529 plans are administered by individual states and, therefore, the details of each can vary. But in all cases, 529 plans offer professionally managed investment solutions—generally consisting of age-based or risk-based asset allocation options. In an age-based plan, the underlying investments become more conservative as the beneficiary approaches college age, whereas a risk-based plan would maintain the same mix of stocks and bonds regardless of the beneficiary’s age (based on the model selected by the account holder; models generally range from conservative to aggressive).
In addition to the tax benefits noted above, 529s provide an effective means for reducing estate taxes while making a generous gift to a child or grandchild. Assets in 529 accounts are considered completed gifts—i.e., once gifted, those assets are not includible in the donor’s taxable estate. Under a special gifting rule, a donor can contribute up to $60,000 per beneficiary per year ($120,000 for married couples filing jointly), as long as no other gifts are made in a five-year period.