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Student Loans: Know the basics before you borrow

As the cost of a college education has continued to rise, 69 percent of college students1 in 2019 took out student loans to make ends meet. Tuition, fees and room and board at private four-year colleges cost on average $49,640, while public universities clock in at $19,640, according to the College Board. While financial aid may cover some of the cost, most students need help paying the bills, and the typical borrower owes $29,900 by the time they leave college—loans they took out when they were barely old enough to vote. Even parents, who guide their high school seniors through the financial aid process, often don't understand the basics of student loans and what's available. Parents themselves hold an average of $37,200 in loans to help their kids get through school. 

Before you or your children sign on the dotted line, here's what you need to know about student loans.

Types of Student loans

There are two types of student loans: federal and private.

Federal Loans:

Students taking at least six credits can take out federal student loans, which are backed by the government. Rules about their terms and conditions are set by law. In addition to fixed interest rates, federal student loans also come with flexible repayment options and, in some cases, loan forgiveness.

Federal student loans can be either subsidized or unsubsidized. Interest on subsidized loans is paid by the government while you're in school, for the first six months after graduation, and during any periods of deferment. Subsidized loans are only available to undergraduates and have smaller loan limits. That's not the case for unsubsidized loans, which have interest that immediately accrues.

Undergraduates can borrow up to $5,500 their first year, $6,500 their second year, and $7,500 their third, fourth, and fifth year through a combination of subsidized and unsubsidized loans. Students who are not claimed as dependents on their parents' tax returns can borrow higher amounts.

Private Loans:

For some students, federal loans may not be enough to cover their college expenses, and they may need to look at other sources of financing for their education. Private loans are available through private entities such as banks and credit unions. The terms for these loans are set by the lenders themselves.

Private loans don't have a borrowing cap, but these loans typically require a co-signer.

When deciding how much to borrow, make sure you're not taking out more than necessary to cover college expenses. A few thousand dollars extra a year may not seem like much more to borrow, but when you factor in interest, you will wind up paying significantly more over the course of your loan.

Student loan interest rates

All borrowers who take out federal student loans in any given year pay the same interest rate, which is reset each July.

For the 2020-21 school year, the interest rate for undergraduates fell to a low 2.75 percent. Students taking out loans for graduate and professional school will pay 4.30 percent and parents 5.30 percent. Borrowers typically graduate with a variety of loans that bear different interest rates depending on when the loans were taken out.

Interest rates on private loans, on the other hand, vary by lender, and they depend on several factors such as your income and your credit score.

Student loan repayment plans

While students are still attending college, paying off loans may seem far away. But the first payment on federal student loans is due within six months of graduation. How will these repayments fit comfortably into your (or your graduate's) monthly budget?

Standard repayment:

A standard repayment schedule consists of 10 years, which dices up the loan amount into 120 equal payments. For the average borrower, that translates to $200 to $299 a month.

Income based repayment:

Federal loans can help borrowers who are struggling with their payments through income-based payment provisions. In that case, monthly payments are recalculated based on how much income the borrower earns, though that may lengthen the term of the loan and the total amount of interest. In addition, federal loans also have deferment and forbearance options, which let borrowers hit the pause button on loan repayments if they're going through a rough financial patch.

These features were on display recently when in response to the economic hardships created by the Covid-19 pandemic, the Department of Education allowed all borrowers with federally-held student debt to halt payments and stopped the accrual of interest on those loans.

Loan forgiveness:

Federal loans also have the possibility of public service loan forgiveness for those who qualify. This program requires borrowers to work for at least 10 years at a not-for-profit organization or the federal government. It's best to check with a loan servicer to understand the requirements of this program since they change frequently.

Private loan repayment:

Private loan repayment works differently. It’s dependent on the lender who extended the credit, but the most common repayment plan on private student loans involves a level payment for a fixed number of years, typically seven to 15 years. Some lenders may offer extended repayment periods of up to 30 years, depending on the amount of debt.

Loan consolidation:

Federal student loans can be consolidated and refinanced into private loans to lock in lower interest rates, which could lower monthly payments. However, make sure your children won't want to take advantage of any federal loan repayment provisions before taking this step.

While altering monthly payments can create breathing room in a budget, extending the life of a loan could mean paying more in total interest. Make sure to take this consideration into account before making changes to the standard payment plans.

With the cost of a college education soaring, a majority of students who earn a bachelor's degree will continue to turn to loans to help finance their education. But with a little research, you can find smarter ways to ensure that the combination of loans you and your children take out are right for you.

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