College Loans 101: The Education of a CPA Parent

By Michael J. Knight

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An article in the Boston Globe talked about Sallie Mae (www.salliemae.com), a government-sponsored lender of education funding. I called the toll-free number, and after 10 minutes of giving information to a very helpful and knowledgeable person, I was approved.

The “Parent (PLUS)” loan that I qualified for was straightforward. I borrowed money to pay the tuition; the interest rate, fixed for one year starting July 1, 2003, was 4.22%. I was so excited that I told other fathers about it, amazed that none of them had heard of the program. One father followed up, but soon was asking, “Why didn’t you tell me about the points that must be paid on the loan?” He said he had talked to three different people at Sallie Mae who gave him two different answers. Several phone calls confirmed that he was right: The Parent (PLUS) loan carries a 3% fee paid to the department of education.

A few days after Sallie Mae preapproved me for a Parent (PLUS) loan, a postcard arrived instructing me to call the indicated telephone number to reconfirm the process. In so doing, I was told that if I paid the loan back on time for 48 months the interest rate would be lowered by 2%, which they had not told me earlier.

Interestingly, the organization that sent the postcard, Next Student, is not part of Sallie Mae, but a competitor. Parent (PLUS) is a federal program open to all lenders. I realized that I had signed two promissory notes—one to Sallie Mae, one to Next Student.

Parent (PLUS) Menu 1: 10-Year Plan

Parent (PLUS) loans are open to all parents of college students, based on credit history; they are not need based. When an applicant is qualified, the lender coordinates with the school’s financial aid office to determine the exact amount of the loan. Once the final payment to the college for the year is made, the repayment cycle of the program begins (generally 60 days after final payment to the college). The basic repayment period is over 10 years. Assuming the student has a $5,000 scholarship, the financial aid office estimates costs of $30,000, and the interest rate is 4.22%:

The monthly payment due February 1 (assuming first payment December 1), estimated over 10 years, comes to $263.41 per month. Over four years, the payments would be as shown in Exhibit 1.

As the exhibit shows, the borrower can elect to pay interest only. In this example, interest-only monthly payments would be $90.55, compared to $263.41 for a 10-year payoff of the principal and interest. The interest-only election can be made for the years the student is in college. Because no principal would have been paid, monthly payments will be higher in years 5 though 10 as the loan is paid off (assuming the rate stays at 4.22%, monthly payments beginning in year 5 would be $1,621.80 for 72 months).

A third way to repay the loan is to request forbearance, which is the term Parent (PLUS) uses to describe a request to pay nothing while the child is in school. The interest is added to the principal, resulting in a bigger loan to repay and higher monthly payments once repayment begins. Assuming the same circumstances, the payments over the first four years would look like Exhibit 2.

Thus, with 72 months remaining on the 10-year schedule (120 months – 48 months deferred), the parents will begin repaying $114,337. The monthly payment for this (assuming the 4.22% rate) is $1,800.30.

Parent (PLUS) Menu 2: 30-Year Plan

This option, called the Federal Consolidation Loan Program, provides the same three methods of payment described above, but over a longer term. The rate is fixed based on an average of the rates on the loans received plus 1/8 of a percent. Assume that the same $25,750 as above is borrowed each year at rates of ranging from 2% to 8%, for an average rate of 5% (20% divided by four years). If the loans are consolidated, the interest rate will be 5.125% (5% + 1/8%), fixed for the term of the loan. The term of the loan is based on the total amount owed based on the following table:

If at the end of four years the amount owed is $103,000 ($25,750 x 4), amortized over 30 years at 5.125%, the monthly payment would be $560.82. This example assumes that the borrower paid the interest during the four years of college and financed the $103,000 after graduation, as demonstrated above. The other two options are also available: interest plus principal, or forbearance (no payments). Using the forbearance numbers from the 10-year plan would produce $114,337 at 5.125% for 30 years. The payments would be $622.55 monthly. To confuse the situation further, the consolidation feature can be elected at any time, year 1, 2, 3, or 4.

Stafford Loans

Stafford loans are given directly to students at rates that are more favorable than Parent (PLUS) loans, but for the same favorable term length. The trade-off is that students can borrow only lower amounts. The Stafford loan rate while the student is in school is based on the 91-day T-Bill + 1.7%. As of July 1, 2004, the rate for the year was 3.1%, significantly better than the Parent (PLUS) loan rate of 4.22%. The Stafford loan interest-rate cap changes every July 1 as the base rate changes, and is currently 8.25%.

The amounts a student can borrow are as follows:

The same three payment options are available to the student while in school as to the parent in the Parent (PLUS) program:

• Payments of interest and principal from inception over 10 years;
• Payments of interest only (interest paid quarterly, not monthly); and
• No payments until six months after school ends.

The Stafford loan does not allow for payments unless the student elects to make payments. When the student begins payments after school, interest is charged using a repayment index of the 91-day T-Bill rate plus 2.30% (2.79% for July 2004). If the student decides to consolidate loans, the rate can be much more favorable than the Parent (PLUS) loan.

The Stafford loan, whether interest is paid or added to principal if not paid, is an unsubsidized loan, and is not based on need. A Stafford subsidized loan is based on need, and no interest accrues during school years nor needs to be repaid during school. Six months after school ends, payments commence for both the unsubsidized and subsidized programs.

Stafford loans are enhanced (“supersized”) when parents do not qualify for a Parent (PLUS) loan. Students can borrow the amounts as listed in Exhibit 3.

Editor's Note: This is adapted from an article published in the April 2004 issue of Financial Planning magazine
(www.financial-planning.com) and is reprinted with permission.