Student loan basics

Having a poor credit history is never an advantage. Fortunately for students and their parents, though, there are a number of loan and aid packages that don’t look at credit status at all. Several Federal loans consider only need or other factors, and ignore any credit history entirely, good or bad.

Pell Grants are one of the oldest, and disbursing them is based primarily on the economic status of the grantee. If the student and his or her parents are a low-income family, Pell Grants are almost automatic. Almost. As with any form of Federal aid, that economic situation has to be demonstrated through supplying documentation.

Those in charge of disbursing Pell Grants use a number, called EFC (Expected Family Contribution), to decide whether to give the money. Other factors also come into play (such as the cost of tuition and more), providing a rounded picture.

The grant is a gift, not a loan and is currently a maximum of $4,050 per year. That may seem like a substantial sum, and it certainly helps a great deal. But with annual tuition upwards of $5,000-$10,000 or more it doesn’t cover everything.

Most students, therefore, will want to seek a loan in addition to a Pell Grant to fund their education. There are many that are similarly need-based. One of the most common are Stafford Loans, which come in two types.

The first type of Stafford Loan, and the most desirable, is called ’subsidized’. The term comes from the fact that the government pays any interest that accrues during the period the loan is not being repaid. That period is typically while the student is carrying a half-time or greater load of classes, and for the first six months after leaving school.

The second type is ‘unsubsidized’ in which the student is responsible for any interest on the outstanding principle. If paid in installments while attending classes, it may be modest. A $4,000 loan paid over 120 months carries a monthly payment of $42.43 at a 5% interest rate. The interest portion is roughly $9 per month. If it accrues unpaid over several years, though, it can add a substantial amount to the total repayment after graduation. Any unpaid amount gets added to the prinicple, with the interest rate applied to the total.

The advantage, however, of the second type is that they are almost always available to any student. In most cases, they won’t cover more than about 25%-40% of the total costs, so students will need to supplement the loan with other sources of funds.

Limits range from $2,625 ($3,500 starting July 1, 2007) the first year, rising to $5,500 for the 3rd and 4th years, for dependent undergraduate students. Independent students can borrow up to $10,500 per year. Graduate students may borrow up to $18,500 ($20,500 starting July 1, 2007), with a total of $138,500 over the lifetime of the education.

Fees apply (up to 4%) to fund the loan, so students will actually receive less than the stated amounts.

Perkins Loans are another type of ‘no credit required’ student loan. A low interest rate loan (currently 5%), it allows dependent undergraduate students to borrow up to $4,000, with a cap of $20,000 total.

Many common student loan programs are not credit-based. Stafford and Perkins are based solely on need and don’t even do credit checks. But not all will qualify and those programs will often cover less than 100% of the needed amount, especially considering the high cost of education today.

Many students and their families will, therefore, want to supplement those with credit-based student loans. When they do, being able to show a good credit report to evaluators will result in better access to funds, with the best possible interest rate.

As with any credit-based loan, a prior history of bad credit doesn’t make getting funds impossible. But it can be much more difficult and often carries a higher interest rate.

Avoiding bad credit history can therefore be the difference between getting a loan or, if you do get one, repaying much more than you would have with good credit. But what is good or bad credit?

The first factor any loan officer will consider is the FICO score. The FICO is a number calculated by the major credit agencies based on a secret, proprietary formula. Though the exact equation isn’t public, several criteria are known, and even obvious.

FICO scores are based on outstanding debt and defaults, number of late payments and how late - 30 days, 60 days, 90 days or longer, amount of credit available, number of recent credit inquiries and other factors. All these are weighed and weighted so that, for example, a default counts very heavily, as do any late payments, with larger late days counting more. The number of recent credit inquiries counts less.

Many students won’t have a FICO score at all, not having credit cards or other forms of loan that would generate the data on which the score is based. But the majority of students are judged by the parents’ credit history, in regard to granting loans. While student credit history is important, the parents income and credit history typically count for more in making a final decision.

Both parties need to have good credit. First and foremost, that means a FICO of above 650, and the higher the better. Having a score lower than that won’t make getting a loan impossible, but it may trigger the need to supply additional information that can influence the decision. And getting that extra data into the hands of actual individuals who can be influenced is not easy.

Apart from the FICO score, and related to it, there are a number of factors that prospective borrowers should keep in mind.

Paying on time is important. Evidence of a history of late payments, incurring late payment charges is evidence of a bad credit risk in the eyes of lenders. Staying within available credit limits is important, as well. Avoiding over limit and other penalties shows a willingness to defer immediate gratification and accept responsibility. Creditors are judging not just numbers, but character as well.

Limiting the number and maximum balance amount on credit cards can also help. Excessive credit inquiries suggest to lenders that someone is having difficulty meeting current debt loads. That’s a signal that repayment of additional loans may be harder. That increases the lenders’ default rates - loans that aren’t repaid. Financial institutions will try very hard to keep that default rate low. To do that, they sometimes deny credit to borderline cases.

Meet all credit obligations and keep all borrowing to a modest level for a long period of time. That makes you look like a very good risk to loan officers, which means funding a student loan will be a slam dunk.

Many of the common Federal student loan programs require no credit check and provide substantial sums for financial aid. Unsubsidized loans, in which any interest accrued while the student is in school making satisfactory progress, are among the most desirable.

But these programs are need based and often carry other criteria that make it difficult to qualify. Even when students (and parents) do qualify, the loans only cover a portion of the total cost of education, in many cases. When students and their parents find themselves in that situation, they can turn to private loans to make up the difference.

Private loans, too, have pros and cons, however. A credit check is almost universally required. For those with a good credit history that’s no problem. But ‘good’ is a relative term and if it isn’t good enough, borrowers will find themselves paying higher than optimal interest rates.

Beyond the stated interest rate, there are other financial implications of private loans. Fees are often tacked on (or, rather taken off) nominal loan amounts. A relatively modest loan of $4,000 may easily have 4% in fees applied prior to distribution. That means $160 of the total is never seen by the borrower, but must be repaid. As a rough guide, every 3% of fees is equivalent to an additional 1% on top of the stated interest rate.

Private loans do have certain advantages, however.

The obvious one was alluded to above: the funds are available. Private lenders exist to make a profit on the interest and fees they charge. They have an interest in making money available to borrowers. As a consequence, they will work very hard to ensure that every applicant qualifies. Federal lenders, on the other hand, have an inflexible set of criteria and there is typically no real appeal if your application is denied.

Not having to deal with that impersonal, often illogical, bureaucracy is another advantage of private loans. Lenders maintain customer service departments that, though understaffed, exist to answer questions so that customers can get answers. Federal loan programs typically have contacts and help available as well. But the answers one gets are hit or miss in terms of quality.

But many other practical considerations apply that make private loans desirable.

Neither students nor parents have to fill out the FAFSA (Free Application for Student Aid) form(s), nor supply the same supplemental documentation. Private loan applications tend to be simpler and the whole process easier. But, fees and interest rates may be higher or lower depending on the individual program.

The most desirable private loans will have no fees and interest rates that are about equal to the prime rate – 1%. The ‘prime rate’ is the rate banks charge one another or their largest, most favored customers. Getting a rate at prime is a good deal, getting a rate at 1% below prime is a great deal. But be sure to check for any fees. As described above, fees can substantially add to the total cost of the loan.

To get that type of loan it’s usually necessary to have a great credit history and/or get a loan with a co-signer who has excellent credit. That situation may or may not apply to you. The only way to know for sure what is available is to dig into the specifics.

Use a loan calculator to run through some sample scenarios, once you have some figures in hand. Be sure to include all the actual costs over the lifetime of the loan, to get a picture of the real cost.

Obtaining student aid can be more complicated than playing the stock market. There are literally hundreds of possible scholarships, loan programs and other forms of assistance. But for the overwhelming majority a Federal student loan program is the most likely source of funds to help pay for school.

Most of that money loaned is associated with one of only half a dozen programs. Stafford (for students) and PLUS (for parents) with a couple of variations cover most circumstances. But beyond the program names/types themselves, there are two common categories that those seeking funding should be aware of. Which you choose can have a substantial financial impact down the road.

The two categories are: subsidized and unsubsidized college student loans. Students generally make no payments on either type until six months after leaving school whether they graduated or not. But because of the fact that interest amounts are calculated on the outstanding principle (the loan amount), it can add up to a substantial sum over a period of years.

Subsidized loans are a type in which the government pays on behalf of the student any interest accumulated on the loan during the years attended. Neither the student nor any co-signer, such as parents, accumulate interest on the principle while the student is in school. The clock only starts ticking six months after leaving.

Unsubsidized loans are the opposite. Though payments may or may not be due during school years, the interest is calculated from the day the loan is funded. Even at a modest amount, say $1,000, at 6% per year a student can incur an additional debt of $60 the first year. That doesn’t sound like much, but that $60, if left unpaid is added to the principle. The following year the interest is %6 of $1,060 or $63.60.

The example is greatly oversimplified, since interest is calculated monthly not annually and so the amount actually rises much faster, in fact exponentially. The interest amounts are typically much larger, too, since loan amounts can easily be 20 times or more than the example. A simple loan calculator will allow the prospective borrower to run through some sample scenarios.

Many loans are a mixture of subsidized and unsubsidized and funds may come partly from a Stafford loan, partly from a PLUS loan, or a number of other possible types and sources. Some students may not qualify for certain Federal student loans, because of parents’ income or other reasons. In that case, private loans and other funding sources have to be relied on.

The only way to know for sure is to fill out the standard FAFSA (Free Application for Federal Student Aid) application, available at: fafsa.ed.gov.

Using that, in conjunction with the required accompanying documentation - showing parents and student income, credit histories, current debt loads and other information - loan officers make a decision about whether or not to grant the loan.

Most students will qualify for at least some aid.

Stafford loans are part of the FFELP (Federal Family Education Loan Program) established by Congress in 1965 to supply financial aid to students. Originally intended to cover those ‘in need’ where the quotes indicate that the definition was somewhat loose even then, it rapidly expanded. Today, Stafford loans provide over 90% of the more than $50 billion dollars distributed every year within the various FFELP categories.

One way the definition of need was quickly broadened was to create two different kinds of Stafford loan: subsidized and unsubsidized.

In the first case, the Federal Government pays any interest that would normally accrue from the time the loan is originated until payments begin. Normally, no payments are due while the student is in school half-time or more, and for a six-month grace period after leaving. Students can request payments to begin earlier.

Since the interest is subsidized, these loans are generally need-based, meaning that aid officials look to student and family income in deciding whether the student qualifies. A number called the EFC (Expected Family Contribution) is used, by examining income information provided on the FAFSA (Free Application for Federal Student Aid) application. Available at: fafsa.ed.gov.

About two-thirds of all subsidized Stafford loans are provided to students whose parents have an Adjusted Gross Income of under $50,000 per year. Another 25% are awarded to those in the $50-100,000 per year range. But the definition of ‘needy’ is indeed flexible, since slightly less than 10% of subsidized loans are granted to students whose combined family income is over $100,000.

For those students who don’t qualify for subsidized loans, most will be eligible for an unsubsidized Stafford loan. Keep in mind, though, that the interest accumulates from the day the loan money is disbursed until the day it’s paid off. Even in the case of a modest $4,000 loan, at 6.8% the first year of interest is approximately $230. That $230 is then added to the $4,000 and interest charges calculated on the higher figure.

Actually, the example is a little oversimplified, since amounts are calculated monthly not annually. The exponential equation underlying it is a little complex, but sample scenarios can be played with by using a loan calculator.

Since $4,000 is a very low amount as student loans go, the numbers can actually be quite a bit higher. The average undergraduate student (and/or parent) borrows about $15,000 per year in a mix of subsidized and unsubsidized Stafford and other sources.

Over the past 40 years, just as with everything else, the cost of education has risen dramatically. Average tuition increases of more than 6% per year are common today. Just as one example, in 1973 the cost of registration at UCLA (University of California, Los Angeles) was $208 per quarter. It is now over $2,300 per quarter.

That ten times increase is not too unusual - many things cost ten times what they did a few decades ago. Income, on the other hand, has risen about three times in the same period, from about $15,000-$30,000 per year to around $39,000-$42,000. The numbers vary by gender, age and more but as a rough guide, the lower range ~3:1 ratio is about right.

Now for the good news. There are more types of financial aid available today to students and parents than there ever has been. Financial aid, as the name suggests, is money that students and their parents get from scholarships, Federal and private lenders and a few other sources, to aid students in paying for education.

Once upon a time, students could depend almost entirely on Pell Grants and Stafford Loans to finance education costs, if not complete living expenses. Pell Grants are still given, but they’re need-based and represent a small percentage of the education cost today. Stafford Loans are also need-based, and can range from 25%-40% of the average cost of financing school. Perkins Loans are similar, but reserved for the lowest income families.

Fortunately, PLUS Loans are available, which was not an option 35 years ago. These are loans to parents, not students, to help pay for the student’s education. The interest rates are average, and there are certain restrictions and fees, but they often form part of the total package.

A word to the wise about fees in general. Many loans are nominally for a specified amount, say $4,000 per year disbursed in two payments (one per semester). But it’s not uncommon for up to 4% in fees to be deducted from that amount before any funds are distributed. That 4% on $4,000 equals $160 you never see, yet have to repay. Be sure to look for low or no-fee loans.

Though Federal loan programs, like the subsidized Stafford and others, carry no credit check and low fees and interest is paid by the government, they are not the only source of financial aid today.

The average financial aid package today will be a complex mixture of grants, scholarships (if possible), Federal and (probably) private loans. Rates range from 5% (Perkins) to the more common 6.8% or higher. With the recent large increase in defaults on sub-prime lending (mostly for mortgages), lenders are going to be more strict than before about credit history and income.

The best way to get started is to look at tables of the most common loan programs, what interest rates and fees they carry along with any eligibility requirements. One excellent site that summarizes much of that information can be found at finaid.org.

Student loan basics is an informational site dedicated to providing you quality articles about student loans.  Please browse our web site for more information on different types of loans.  Please understand that while we strive to provide accurate information at all times, you should always seek advice from a financial expert or attorney before proceeding.