By ANNAMARIA ANDRIOTIS (SmartMoney.com)
Some families are foregoing pricey student loans in favor of alternative strategies. We weigh the pros and cons.
College-tuition bills at most schools are due in August, and parents are likely to borrow even more this year than last.
But parents might not borrow the way their parents did — or even like their neighbors just a few years ago.
Federal student loans have long been the option preferred by most borrowers. But annual interest rates on many of these government loans range from 5% to 7.9% at a time when mortgages are going for around 3.5% or less.
In June, Congress extended the 3.4% interest rate on subsidized Stafford loans for one more year, but unless Congress intervenes again the rate will double next year. Private student loans, meanwhile, can be far pricier, with rates as high as 16%, largely determined by borrowers’ credit scores.
Most college loans remain relatively expensive compared with other loans. As a result, many families are turning to unconventional methods. Among them: tuition installment plans, zero-interest loans from colleges, home-equity loans, insurance and even credit cards.
“If you’ll be paying at least two percentage points lower than the interest rate on federal loans, it’s worth seriously considering” alternative payment strategies, says Mark Kantrowitz, publisher of FinAid.org, a for-profit website that tracks student loans.
Many of these nontraditional methods carry another advantage besides lower costs: The debt can be wiped out if a borrower falls on hard times. Federal and private student loans typically can’t be walked away from in bankruptcy. That could appeal to parents who worry their little darling might turn out to be a deadbeat on a loan they co-signed.
The search for cheaper financing comes as tuition costs reach new peaks. At least 123 institutions charged $50,000 or more for tuition, fees, room and board during the 2011-12 academic year — 2.8% of all degree-granting colleges — up from 58 schools in 2009-10, according to the Chronicle of Higher Education.
The annual cost at four-year private nonprofit colleges averaged $38,589 in 2011-12 — a 14% increase after inflation from five years earlier, according to the College Board. The in-state cost at four-year public colleges rose 20% over that period, to $17,131, on average.
Average household income, meanwhile, fell 6% to $67,530 between 2006 and 2010, after adjusting for inflation, according to the latest data from the U.S. Census.
At the same time, scholarships and grants are harder to get. Just 35% of families used scholarships during the 2011-12 year, down from 45% the year before, according to Sallie Mae, the largest private student lender. As a result, families used loans to cover 27% of college costs during the last academic year, up from 22% the year before, according to the lender. Collectively, families used grants and scholarships to cover 33% of college costs during 2010-11; that fell to 29% last year.
Beth Marer-Garcia of Palo Alto, Calif., says she and her husband, Julio, an engineer, will pay for their two children’s college education this fall with a mix of savings, student loans and their home-equity line of credit. They were enticed by the credit line’s low rate of roughly 4% and the fact they could claim the interest on the amount tapped as a tax deduction.
“It just made sense,” she says.
To be sure, while alternative strategies might be cheaper, they can present other problems. Parents who use home equity to cover tuition risk going into foreclosure if they fall behind on payments. And if credit-card debt isn’t paid off during the 0% interest period, which, if offered, typically lasts about 10 months, cardholders could face rates of up to 20% or more.
Families also should consider their tax bills. Up to $2,500 in interest paid on student loans each tax year can be deducted as an above-the-line exclusion from income. With married couples filing jointly for the 2012 tax year, the deduction begins to phase out if their modified adjusted gross income exceeds $125,000 and eliminated entirely once it hits $155,000. With the other types of loans, the tax treatment varies.
Here are some ways families are trying to fill the college-tuition gap, along with the pros and cons.
Tuition Installment Plans
Interest Rate: None
Some 90% of colleges offer these plans, which allow families to spread tuition payments over nine to 12 months, according to the National Association of College and University Business Officers, which represents chief financial officers at nonprofit public and private colleges. Most plans don’t charge interest, though many levy an enrollment fee of $40 to $75 or more.
The strategy also can appeal to parents who don’t want to make large withdrawals from their savings, because they can keep earning interest — meager though it might be — on the amount still sitting in the bank.
Rather than pay tuition for their son at the University of Dayton in Ohio in one lump sum, Todd Hartshorn and his wife, Virginia, plan to sign up for an installment plan next month. Mr. Hartshorn, a manufacturing manager in Cincinnati, says the couple will withdraw $2,000 from savings and investment accounts every month for 10 months. His rationale: “If I’m only pulling out [money] when I need it, it’ll continue to gain interest as long as possible.”
Warning: If you fall behind on the payments, the school could block your child from registering for the next semester.
Zero-Interest Loans
Interest Rate: None
When Jennifer Cray’s daughter begins classes at Occidental College in Los Angeles this year, her tuition will be covered in part with a no-interest loan she was offered by the school.
“That’s a big difference when you compare it to federal loans,” says Ms. Cray, a financial planner in Menlo Park, Calif.
As college endowments bounce back from their financial-crisis lows, some schools are lending money to students with rates as low as 0%, says Justin Draeger, president of the National Association of Student Financial Aid Administrators. Schools, eager to attract students, can include these loans in their financial-aid letters.
All types of loans made by colleges have grown from about $500 million in the 2007-08 academic year to roughly $720 million in 2010-11, according to the College Board. Terms vary by school; repayment can be as short as one semester to as long as 10 years after graduation.
The downside? Not everybody is eligible. Families might have to display need and the ability to repay. And if borrowers fall behind on their payments, in some cases even by as few as 30 days, the interest rate could spike up to 9% or more. Plus, like regular student loans, most of these loans can’t be wiped out in bankruptcy, Mr. Kantrowitz says.
Home Equity
Interest Rate: About 3% to 6%
Tapping home equity to pay for college can be relatively cheap. Rates on home-equity loans and lines of credit average about 6.4% and 5.1%, respectively, according to Bankrate.com.
And that’s before the tax breaks. Homeowners can take an itemized deduction for the interest paid on home-equity debt of up to $100,000 used for any purpose, including college. The higher one’s tax bracket, the bigger the advantage likely will be. However, for tax filers who are subject to the alternative minimum tax, home-equity interest deductions are allowed only when that debt is spent on home improvements.
Traditional home-equity loans mostly charge fixed rates, and the borrower gets the money in one lump sum. Home-equity lines of credit allow borrowers to tap the credit line as needed, and the rate is typically variable.
Homeowners also can use their primary mortgage to pay for tuition. Mike Skolnick, a financial adviser in Danville, Calif., says he recommends a “cash-out refinance,” in which a borrower refinances his house while also withdrawing equity. Be warned: Cash-out refis as well as home-equity loans and lines of credit are harder to get now than before the recession, and most lenders require that at least 20% to 25% of equity be left in a home after making withdrawals.
There are additional risks. Falling behind on payments could lead to foreclosure. And if borrowers place some of the withdrawal from a home-equity loan, a line of credit or cash-out refi in a bank or brokerage account, it will likely lead to a smaller financial-aid package for the next academic year. Schools’ financial-aid offices review families’ assets, including bank and brokerage accounts, to help determine financial-aid awards.
Credit Cards
Interest Rate: 0% during introductory period
Parents who know they will be able to pay tuition bills soon — for instance, if they are expecting a bonus or tax refund — might want to consider using a credit card that has a 0% promotional interest rate.
The average length of 0% periods on purchases ran nearly 10 months during the second quarter, up from about eight months a year prior, according to CardHub.com, a credit-card comparison site. For example, Citigroup’s Simplicity and Diamond Preferred credit cards offer 0% rates for 18 months.
Janet Smith and her husband, Gary, used a 0% six-month credit-card offer to pay for about $7,000 of their son’s tuition last year at Pepperdine University in Malibu, Calif.
Ms. Smith says they began this strategy when the couple, who own a diversity consulting and training firm in Rockville, Md., had three children in college at the same time and found themselves short on cash. The 0% period gave them more time to save up, she says, and they paid off the debt before the rate spiked.
Another perk: In some cases, cardholders can earn rewards points when they charge college costs to their credit cards.
There are downsides, though. Some colleges don’t accept credit cards for tuition payments, and in some cases, there is a 2% to 3% fee if tuition is paid with a credit card.
What’s more, if parents don’t pay off the debt during the introductory-rate period, they likely will incur interest rates ranging from 12% to 23%, according to CardHub.com. To avoid that, parents can move their balance to a card with a 0% promotional rate on balance transfers, though the average fee for that is nearly 3%.
Life Insurance
Interest Rate: 4% to 5.5%
“Permanent” life-insurance policies combine a death benefit with a tax-advantaged investment account, and policyholders can borrow cash from the policies to pay for various expenses. Parents can take loans from such policies to cover tuition bills.
Interest rates on these loans, which can be fixed or variable, typically range from 4% to 5.5%, says Scott Moffitt, a college-planning consultant in Cincinnati. That’s lower than most federal and private student loans.
Still, there are plenty of downsides. If a policyholder dies before paying back the loan, the insurer will pay a smaller death benefit to beneficiaries than the policyholder had intended. The same holds true if the policyholder makes a withdrawal.
Separately, permanent-life policies charge higher premiums and fees than term policies, which provide a death benefit only. Experts say rather than paying higher premiums, policyholders can save the difference and invest it in a lower-cost vehicle, such as a 529 college-savings plan.
Still, unlike 529 plans, Coverdell accounts and other popular college savings vehicles, the asset value of life-insurance policies typically isn’t included in calculations for financial-aid eligibility.
Alternative Loan Sources
Interest Rate: Varies
Since last year, a small number of start-ups have launched offering loans to students.
This month, SoFi, based in San Francisco, began making loans to undergraduates at 45 colleges, including New York University, Northwestern University and the University of California, Los Angeles. Alumni of those institutions fund the loans.
The interest rates are fixed at 6.49%, and they can drop to 5.99% upon graduation. Loan payments can be deferred until six months after graduation, though interest begins accruing while the borrower is in school.
David Bowman, 29 years old, of Palo Alto, Calif., signed up for a SoFi loan last year when the company was lending solely to students at the Stanford Graduate School of Business. He says the rate was lower than other student-loan options.
The company also offers income-based repayment plans, in which borrowers with low-income jobs pay no more than 15% of their so-called discretionary income. Borrowers also can ask for loan forgiveness. But when it comes to bankruptcy, SoFi loans are like all student loans: They can’t be wiped out.
Another recent start-up, the online platform Weemba, helps students and other borrowers connect with banks and other lenders, such as credit unions and nondeposit lenders. Constancio Larguia, the site’s founder and chief executive, says borrowers can cast a wider net to find lenders who might be offering better terms than their local bank.
Loan rates are determined by the lenders who offer them, and Weemba has no role in the loan-approval process. Loans may or may not be eliminated in bankruptcy, depending on the type of loan borrowers get.
