Every wonder what the amount of debt on your student loan translates in terms of payment?
Watch our Video above to see how knowing in advance and being intentional with how you pay for college can have a tremendous impact on both the student who graduates with Student Loan Debt and the parents who may be thinking about retirement. For the Dave Ramsey listeners this is all about Baby Step 5 and how you can be intentional in your spending.
This section highlights advantages and disadvantages of various loan strategies. They are ranked in descending order based on the pros/cons of each. We are providing this information so you have expectation of what these costs are. The best bet is not to have any loans, but as a practical consideration we would rather arm you with information so you can be intentional with how you choose to go about paying for college.
Stafford Loans-Federal Direct Loans
Stafford loans are fixed rate and are not based on financial need. Therefore, the student can obtain this loan, regardless of whether the family qualifies for financial aid. The current Stafford loan interest rate is fixed at 4.53%. These loans are taken out in the student’s name and therefore, the student will be entitled to the student loan interest tax deduction.
The amounts that can be borrowed by the student are as follows:
- Freshman year – $5,500
- Sophomore year – $6,500
- Junior – 5th year – $7 ,500
The total undergraduate amount of Unsubsidized Stafford loans that a dependent student can have is
The repayment of the Unsubsidized Stafford loan interest begins within 60 days after the final loan disbursement. However this interest can be deferred. The principal repayment does not start until six months after the student graduates, leaves college, or drops below half-time enrollment.
T I P : A Stafford Loan usually offers more benefits for the student than a PLUS loan taken out by the parents and therefore should be considered before a PLUS loan. Here are a couple of reasons:
- The interest rate on a Stafford Loan is lower than the interest rate on a PLUS
- Once the student graduates and is no longer a dependent, he can likely claim student loan interest deduction – up to a maximum of $2,500 for each of the 5 years the interest is paid – since his income will likely be below the phase out These tax savings can help pay back the loan.
If the parents have assets (cash) earning a low interest rate, there may be a mutual benefit for the parents and the student to have the parent loan money to the student from this account. By charging interest on the family loan that is greater than the earnings on the parents savings but less than the rate that the student would have to pay otherwise, both parties win; the parents can increase their earnings and the student can benefit from interest lower than they would otherwise have to pay.
Private Student Loans
Generally, a private student loan should only be considered after the student has borrowed the maximum amount of Stafford Loans. These loans are similar to a PLUS loan, but are in the student’s name. The loan can be approved based on the student’s credit. However, by applying with a co-borrower interest rates and fees may result in lower interest rates and fees on the loan. Since repayment of these loans can be deferred until after the college years, a student who does not qualify for subsidized loans may be able to take the interest tax deduction for the interest paid on the loan. Could be preferable to a PLUS loan if the parents have phased out of the interest deduction.
You may consider using the equity in the home to help pay for college. If you have phased out of the student loan interest deduction (therefore no longer available on PLUS loan interest) then the mortgage interest deduction on the home loan will reduce the real interest rate on the loan. The higher your income, the lower the real interest rate on the home loan (the higher your tax bracket, the greater the interest deduction on the loan). Consider alternatives to using the equity in the home in the form of a non- productive loan. Consider carefully the decision to borrow equity from the home to acquire a depreciating asset, such as a loan. If you are willing to borrow against the equity, consider the benefits of borrowing the equity and investing it in an asset that could be liquidated or borrowed against for college expenses. With interest on the borrowed funds tax deductible (effectively increasing the spread on the cost of borrowing and the return on the investment), and by investing the equity in something that earns compounded interest, you may be able to create an excellent source of funds for college and even retirement – as opposed to simply using the equity in the form of a loan.
Home Equity Lines of Credit
If a home equity line of credit is used to fund college, only the amount of money needed for that year can be borrowed. Therefore, interest will only be paid on the borrowed amount. Cash outflow can be minimized during college years by making only interest payments and larger payments after college. Note that only the amount of the line of credit advanced is considered a debt against the equity and remaining equity will be assessed until it likewise is advanced. Under current tax law, interest deduction on equity lines of credit are no longer tax deductible. However, you may find that a home equity line of credit may offer more favorable interest rates than other options.
The repayment term on residence loans is usually longer than other types of loans, which makes the monthly payments smaller and helps with cash flow.
The benefits of borrowing from retirement accounts are reasonable interest rates, repayment terms, and ease of obtaining the loan. However, if these loans are not repaid within a certain period of time, usually five years, the outstanding principal balance will become taxable income and subject to a 10% penalty if the borrower is under age 59 1/2.
Warning!:: If a parent loses his job, or changes jobs, the outstanding balance must be immediately repaid on a retirement loan, or it will become taxable income, subject to ordinary taxes plus penalties.
Also, even though the retirement fund is earning interest on the college loan, it is foregoing the higher rate of return it was earning in the investment.
Some retirement plans may disallow distributions before retirement. However, hardship distributions from 401(k) plans (subject to the 10% penalty) are allowed to meet certain college expenses.
Warning!: Due to the significant limitations and penalties, borrowing from your retirement funds to pay for college should generally be avoided. In addition, if you borrow from your retirement account for college expenses you will not be able to deduct the interest as student loan interest on your tax return.
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Would You Like Help Creating A Plan For Your Child's College Fund Or Your Own Retirement Needs?
We Help Families & Individuals Create Financial Plans For Success.
Mark Kelly, Certified Fee-Only Raleigh Financial Planner™
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