It’s financial aid season, with college applicants and their families filling out the Free Application for Federal Student Aid (FAFSA) to find out how much federal student aid they’ll receive. For the majority of students, however, this aid will make up only a portion of the funding needed to cover higher education costs. Many will turn to student loans to cover the difference.
It is important that prospective borrowers and their families remain vigilant about borrowing for college in order to avoid the financial burden of large student loan debt down the road. Here are some key considerations to help manage student loan debt wisely.
Consider price of schools
There are a lot of factors that go into selecting an institution of higher education, but be sure to include price among them. Review all options with an eye for value, and consider an option that has worked out financially for many students: two years at a community college. Many credits can be obtained at a two-year school for a fraction of the cost, as long as they are transferrable. The price tag of a chosen school will impact the amount of loans that may need to be incurred.
Explore all financing options
There are ways to limit the amount borrowed, such as paying what is possible from existing savings or cash flow, applying for all possible scholarships, aid or grants, and using education tax credits when applicable. Students can help reduce the amount borrowed by earning or saving money while in school. For example, early graduation cuts down on tuition costs, work/study programs can help generate income during the semester, and room and board costs are eliminated if the student lives at home.
Recognize types of loans
For most students, loans are a necessary financial tool. There are important differences in the types of loans available, so make sure to consider federal loans first. These loans offer better terms than private student loans. Parents can also explore taking out a federal PLUS loan up to the full cost of the education. Keep in mind that PLUS loans typically carry a higher interest rate, and cannot be transferred from parent to child, which means the parent is solely responsible for repaying the loan. When exploring financing options, however, it is critically important that families avoid drawing down retirement funds. After all, students can take a loan out for school but parents cannot take out a loan for their retirement expenses.
Estimate monthly cost
Loans can seem like an abstraction when thought of as a whole, so to help students and families get a real-world sense of what loans will truly cost, break it down into monthly payments. Seeing how much will need to be paid back each month can help determine affordability. For instance, a $40,000 loan translates into a monthly payment for $410.52 at 4.29 percent over a 10-year fixed term.
Understand impact of student loan debt
Whether you are a recent college grad looking to purchase a first home or an empty nester looking to downsize, repayment of a student loan can have a negative impact on your credit worthiness. Lenders utilize a metric called debt-to-income ratio (DTI) to measure credit worthiness. DTI is calculated by dividing total monthly debt payments by gross monthly income, which include student loan, auto, and minimum credit card payments in addition to housing costs (mortgage and property taxes or rent). As a rule of thumb, a DTI of less than 36% is ideal, and a DTI of more than 43% can prevent you from being eligible to receive a qualified mortgage from certain lenders.
Thinking through the financial consequences of student loans before enrolling in college is a sensible way to reduce stress and cost after graduation. It is also important to revisit financing options if family financial circumstances change. The team of financial advisors at RKL Wealth Management can help students and their families plot a responsible course for student loan debt management. Contact us today.
Contributed by Judson S. Meinhart, MBA, of RKL Wealth Management LLC. Judd provides investment management and comprehensive financial planning services for his clients and their families.
