College Loans, and Why You Might Want Them

If you've been following me for a while, you probably know...well, very little about paying for college, except that 529's are a pretty good thing. But what about student loans? How do they work? Should they be avoided like the plague? Can you even get student loans on a tech professional's salary?

Let's dive in, shall we?

Recap: Saving For College 101

As I mentioned, 529's are a great way to save for college. The article linked above goes into more detail, but I want to highlight a couple things here.

The basics: if you're in a state with income tax, 529's are a great way to get a state income tax deduction, and whether or not your state has income tax, the investment earnings are tax free -- as long as you use them for qualified education expenses.

Now, if you live in a state with no income tax and aren't yet maxing out your Roth IRA, strongly consider doing that before contributing to a 529. Roth IRA's are more flexible in terms of withdrawals, have more variety in terms of investment options, and provide the same tax-free growth as 529's.

Note that 529's allow you to switch beneficiaries and transfer money between accounts of e.g. siblings, but the penalties for pulling money out of a 529 for non-education expenses are severe. Consider putting part of your college savings in taxable accounts, in order to maintain flexibility in the event that your children's college expenses are lower than expected!

Finally: start saving for college the moment your child is born. Do not wait until "your cash flow is better". Yes, daycare is expensive; if necessary, start small and incrementally increase your contributions until you hit your target. But if you wait until cash flow is better, you'll blink and your kids will be 15!

Federal Direct Loans

Some of this you may already know, and some you may not, so read this through. I'll try to make it quick and un-boring, focusing on the highlights, making some assumptions and saving the subtleties and nuances for another day.

The federal government offers what they call "Direct Loans" (the loans formerly known as Stafford), which are often a great starting point. The main flavors for these are Subsidized, Unsubsidized, and PLUS. (There's also Consolidated, but that's more about logistics and convenience.)

Subsidized and Unsubsidized both have the same interest rate and general terms (more on that later), but differ in one key way: the government pays the interest on your subsidized loans while you're in college. PLUS is for grad students and for parents of undergrads; the interest rates are generally higher than Subsidized and Unsubsidized loans.

So if you're looking at an undergrad, why would you ever use any loan type other than Subsidized? Two reasons: you have to prove financial need, and even if you do, there's a Subsidized Loan Limit. (As of 2020, for dependent students it's $3500 for freshmen, $4500 for sophomores, and $5500 for undergrads after that.)

And yes, Unsubsidized loans have limits, as well -- $2000 each year for undergrads as of this writing, and $20,500 each year for grad students. The limit on a PLUS loan is the total cost of attending the school after financial aid -- in other words, this loan lets you "fill in" the amount necessary after you've hit your limits on the other loans. Oh, and neither of these have income limits -- you can potentially get access to them no matter how much you make!

As far as the term goes, they default to the ten year maximum, though you can stretch it out to 30 with a federal consolidated loan -- and there's no penalty for prepayment, so you can pay it off earlier if you want.

Private student loans

Of course, you don't have to borrow from the federal government if you don't want to (or are somehow ineligible). There are a host of student loan providers happy to take your interest. It's pretty rare (if ever) that they can beat the rates on the non-PLUS Direct loans, especially if you're an undergrad, but PLUS loans are another matter. Depending on your credit score, you may be able to get a better rate with a private student loan than you could on a PLUS loan.

So if you're taking out the loan and looking at PLUS versus private, should you just go with whoever has the lower interest rate? Well...possibly.

First, make sure you're looking at an apples-to-apples comparison: once you've borrowed the money, federal loans have a fixed income rate for the life of the loan, while private loans can be fixed or variable. (In 2020, interest rates are at historic lows; how much do you really want to bet that they won't rise over the next 10 years?)

Also, be aware that federal loans sometimes get extra benefits. For one, they're eligible for Public Student Loan Forgiveness, which is a really nice program if you're planning to go into the public or non-profit sector. For another, if there's...oh, I don't know, say a global pandemic...they're eligible for temporary forbearance, where interest rates are set to 0%.

But I've been a good saver; why take out a loan at all?

All of the above is immediately relevant if you don't have the funds set aside to pay for your child's education -- but what if you do? Should you even care? Actually, yes, for a couple reasons.

Reason number one: I'm a fan of arbitrage, of optimizing the efficiency of investments wherever possible. As of this writing, JP Morgan's long-term capital market assumptions are pegging expected returns on global equity at 8.1%. Simultaneously, the (fixed!) interest rate on non-PLUS direct loans is 2.75%. Now, this is clearly not an apples-to-apples comparison; the tax treatment of a portfolio is different from that of a student loan, and a portfolio has a highly variable return, while a loan's return is fixed. Still, when you're looking at over a 5% difference, it's worth considering -- especially when you consider that as of the SECURE Act, you can now use 529's to pay off at least part of your child's student loans directly!

And reason number two: student loans give your child "skin in the game". Up until this point, I've been assuming that you, kind parent that you are, are planning to pay all college expenses, but you may not necessarily want to! Sure, no one wants their children to drown in debt...but if we're talking about a $10K-$20K loan, then that's roughly $100-$200/month for ten years, depending on the rate -- just enough to potentially dissuade them from treating college as an entitled free ride. Now, you know your child better than I do, but if you're looking for a "disentitlement" knob to turn, consider this one.

Oh, and by the way, because federal student loans don't have a prepayment penalty, if you decide down the line that you want to go ahead and just take care of the debt, you can. Or you can even just pay the debt's monthly payment on your child's behalf, which can help give them a jump-start on their credit score. (Just don't miss any payments, and remember that this is a "gift" for estate tax purposes!)

"So...what you're saying is that I should complete the FAFSA?"

Why yes, and thank you for asking! If you don't get anything else out of this article, do this: every October starting your child's senior year of high school, fill out the FAFSA. Even if you think "we make too much money to get financial aid" -- remember, several of the loans above have no income limit! Every year. Call or email me and I'll help, if you need it. Just do it! Better to have access to the financial aid and decide you don't need it than to lose the opportunity!