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Sometimes taking loans is necessary in order to pay for private school and college. The following is an overview of the common types of loans associated with education funding, followed by a bit of guidance to help you understand which loan(s) might be best for you and your child.
These loans are taken out by parents and typically have an interest rate of prime + 0%-5% depending on the parent's credit score. They commonly offer repayment periods of up to 20 years. Most private schools provide parents with information on this type of loan. Parents can borrow up to the cost of attendance each year.
The Stafford loan is the most common loan that students use to pay for college. If the student qualifies for a subsidized loan, the federal government pays the interest on the loan while the student is in college - hence the term "subsidized." Almost any student can get an unsubsidized loan, with the difference being that the student is responsible for paying the interest on the loan while he is in college, although the interest payments can be deferred until shortly after the student graduates or leaves college.
The amount of both types of Stafford loans for undergraduate students is based on the student's standing in college. The maximum loan amount is $5,500 for freshmen, $6,500 for sophomores and $6,500 for juniors and seniors, with an aggregate maximum loan amount of $31,000 per student.
This federal loan is offered through colleges to parents with relatively good credit. The interest rate on this loan is capped at 8.5%, and repayment begins shortly after the funds are disbursed. The maximum PLUS loan amount is the difference between the college's cost of attendance and all of the other aid that your child has been awarded.
The Perkins loan is awarded by participating colleges to students with exceptional financial need and has an interest rate of 5%. The maximum amount for this loan is $4,000 per year with an aggregate maximum of $20,000 per student.
These loans are offered to students by a variety of banks and private lenders and typically carry very high interest rates, fees and other charges. They should be called "No Alternative Loans" because they should be your last resort.
It is not uncommon for parents to take out a new mortgage on their home in order to pay for college. After all, most parents have the majority of their net worth tied up in their homes (and their 401k or other retirement plans).
A cash-out refinance of a mortgage is when the borrower refinances an existing loan by taking a new mortgage for an amount that is higher than the existing loan. The lender then pays off the existing mortgage and gives the borrower "cash-out" of their home in the amount of the difference between the new higher loan and what was owed on the existing loan.
By contrast, re-mortgaging a home simply means to take out a new loan equal to what is currently owed, but usually at a different interest rate and a different period of repayment. Essentially the goal in re-mortgaging an existing loan is to reduce the payment by getting a lower interest rate, stretching out the payments over a longer period of time, or both.
Instead of taking a mortgage against your home, you can also tap into your home's equity by taking a home equity loan where you get cash-out up front and have a variable or fixed interest rate for a fixed period of time. Or you can get a home equity line of credit (HELOC). A HELOC is a line of credit that you can draw on when you want, and then make payments according to the amount of the available credit that you use. The interest rate is usually variable.
Mortgages can come with fixed, variable and adjustable interest rates, and typically offer longer terms of repayment than home equity loans. One good thing is that the interest can be tax deductible for most taxpayers who itemize their deductions on their tax return.
However, ALL of these loans are collateralized by your home, and if you can't make the payments on the loan, the lender can foreclose on the loan and you can lose your home.
The two big advantages of this type of loan are - typically lower interest rates and little or no paperwork to get "approved" for the loan. They also have one big downside, which is the fact that you are borrowing from your family and if you don't repay the loan according to the terms agreed upon it can cause stress within the family.
Whole life, variable life and universal life insurance policies all have a cash value component that can be borrowed against. The interest rates for loans on these types of policies will vary among companies and policies, but generally range from 5%-9% annually. As the owner of the policy, you determine when to repay the loan. However, if you don't at least pay the interest on the loan each year, the interest charges from the loan will begin to eat away at your cash value and could eventually put your policy at risk of having insufficient cash value to stay in force over time, even if you continue to pay the normal premiums.
In most households these days, at least one parent has a 401k retirement plan through their employer and makes regular contributions to the plan directly out of their paycheck. Most of these plans have a loan provision that permits account owners to borrow from their savings. The maximum loan by law is 50% of the vested account balance, and must be repaid within five years through payroll deductions. The interest rate is set by the plan and is usually tied to the prime rate. The problem with 401k loans is that you have to repay them over such a short period of time (five years). If you fail to do so, the unpaid balance of the loan is treated as a non-qualified withdrawal and therefore is subject to ordinary income tax rates plus a 10% excise tax (penalty) if you are not over age 59 1/2.
Various studies have shown that when students are at least partially responsible for paying for their own college education - by way of work-study, using their own money or taking out student loans - they tend to do better academically than students who are not responsible for any share of their education costs. As parents, if you want your child to be responsible for paying a part of her college costs and she will need a loan to do so, you can either lend her the money yourself (Intra-family loan) or let her take out a student loan. Depending on whether she demonstrates a financial need, exceptional financial need or no financial need at the college that she attends, she will end up with a subsidized Stafford loan, a Perkins loan, an unsubsidized Stafford loan and/or an Alternative loan.
In general, the best loans are the subsidized Stafford and Perkins loans followed by the unsubsidized Stafford loan, and as a last resort, the Alternative loan.
Special offers from lenders change constantly for these loans, so it may require some homework using the internet and by talking with your private school/college to determine which lender has the best overall rates, origination fees and repayment terms.
Generally, mortgages offer the longest terms of repayment with the lowest interest rates, and the interest for some taxpayers is even tax deductible. For these reasons mortgages frequently have the lowest monthly payments for a given amount of borrowed money. Home equity loans and lines of credit have to be repaid over shorter periods of time at higher rates of interest, so their payments tend to be higher than mortgages. But remember that all of these types of loans require a credit check and are collateralized by your home.
Intra-family and life insurance cash value loans don't require a credit check and can be paid back on more flexible terms and decent rates of interest.
Parent PLUS Loans are a good option for parents who don't have a home or don't have enough home equity to tap into. In fact some lenders argue that for education purposes a Parent PLUS Loan might be better than a mortgage or home equity loan since the loan isn't collateralized by your home, the interest rate is fixed and can be tax deductible, it has slightly more repayment flexibility during financially challenging times and is insured against death and disability.
401k loans have to be repaid over shorter time periods than the other loans and usually have a higher rate of interest that is not tax deductible.