Student Loans Demystified

Updated on December 3, 2007.

FINANCIAL AID is quickly becoming a synonym for student loans. These days close to half the students in four-year colleges take out loans — and it's a rare student that isn't confounded by the process. This section should help to clear up some of the confusion.

The three most common government-sponsored education loans are called Stafford loans, Perkins loans and Plus loans.

Stafford Loans are those that students borrow themselves. Loans disbursed after July 1, 2006, have a fixed interest rate of 6.8%. Loans disbursed previously are capped at 8.25% but can vary below that ceiling annually. Students who take out Staffords are limited to $3,500 the first year, $4,500 the second and $5,500 the third and fourth (and fifth, if need be) and $8,500 per year for graduate school. Undergraduates can borrow up to $23,000 total, while the cumulative limit for undergraduate and graduate borrowing is $65,000. Eligible borrowers can get part or all of their loans subsidized — meaning that the government pays the interest while you're in school. You don't start paying off the loan until six months after graduation or your withdrawal date.

Perkins Loans are the other type of federally subsidized student loans. They carry a fixed interest rate, currently 5%, which is deferred while the student is in college and the first nine months after graduation. Undergraduates can borrow up to $4,000 a year, with a cap of $20,000. For graduate students, Perkins loans are capped at $6,000 per year and $40,000 overall, including any Perkins loans borrowed as an undergraduate.

PLUS Loans are those the government sponsors for parents. Loans disbursed after July 1, 2006 have a fixed interest rate of 8.5%. For loans disbursed previously, the rates were capped at 9% but can vary below that ceiling annually. Students can borrow enough to cover attendance minus any financial aid and loans that they're receiving, says Lee Anne Hannula of the Student Loan Network. (The school may certify an even higher amount to cover additional costs, such as living expenses.) Students have to start repaying the loan immediately. They can arrange to make their money payments via auto debit from their bank accounts, but the loan always remains under the parent's name until it's paid off.

There's more to getting a Stafford, Perkins or Plus loan than simply filling out the forms however. Before you borrow be sure to review these three important points:

Who Should Borrow, You or Your Child?
It used to be the student had to max out on Stafford loans before their parents could take on a PLUS. No more. Parents are now eligible to borrow the entire cost of college whether or not their children took advantage of the Stafford program. But even if you plan on repaying the loan yourself, have your child borrow first. Students get the lower rate on Stafford loans and an attractive fixed rate on Perkins loans, and can defer the interest payments. Moreover, your child is more likely to benefit from the deductability of student loan interest. Singles who earn less than $70,000 and joint filers earning less than $140,000 can deduct at least part of their student-loan interest charges up to a maximum of $2,500. Finally, some employers agree to help new hires pay their educational debts, so there's a chance your kid may get bailed out at work.

If you still need to borrow from the PLUS program, but your credit rating disqualifies you, you do have a fall back. Your child will be allowed to get unsubsidized Stafford loans; the limits are $4,000 in the first and second year and $5,000 in the third and fourth year. Graduate students are allowed to borrow up to $12,000 in unsubsidized loans per year.

What Lender Should You Choose?
If your college participates in the direct-student loan program then the choice is made — you should get your loan through the college. But if you're looking for a private lender there can be vast differences among the various institutions that offer student loans. Be sure to ask any lender you're considering the following questions:

· How frequently do you calculate interest on the loan?
The more often interest is calculated, the bigger your child's debt will be when it's time to pay up. For instance, on a $12,000 unsubsidized Stafford, if interest is calculated quarterly over four years instead of just once at the time repayment starts students graduate owing hundreds more.

· Do you offer repayment rewards?
Banks don't like to chase defaulters, so some offer incentives for on-time payments. National lenders Sallie Mae and Nellie Mae, a New England-based lending agency, offer 0% origination fees (the federal tax that accompanies a Stafford loan) to every customer with the loan. They'll also reduce your rate by 50 basis points if you authorize automatic monthly deductions from your bank account. If you become a member of Sallie Mae's subsidiary Upromise, you'll receive rewards ranging from 1% to 10% of the purchase price, which you can apply to your Sallie Mae or Nellie Mae account. (Participating companies include McDonald's, Bed Bath & Beyond and ExxonMobil.)

If you have a Sallie Mae student loan, you can earn a loan credit equal to 4% of your monthly payment amount each month that you pay on time during the first year and another 1% of your original loan amount if all of your payments are on time during the first two years. With a Nellie Mae loan, you'll receive a 3.3% credit to your account after you pay on time for the first 33 months.

These rewards are eligible for loans taken out between July 1, 2007 and June 30, 2008. Benefits typically change each year, says Sallie Mae spokesperson Martha Holler. Students who took out loans prior to July 1, are eligible for the rewards available at the time their loan was disbursed. For more information, log onto your account on Sallie Mae or call customer service at 888-272-5543. For Nellie Mae, call 800-634-9308.

· Do you have a payment plan?
If you know you'll be taking out at least one loan, make sure that your lender has an attractive consolidation plan, which can help reduce your out-of-pocket costs when you start repaying.

· Are there state-run incentives?
Many individual states are now offering subsidies on student and parent loans. Be sure to check with both your home state and the state where your child's school is located.

Before You Pay Up
You want a lender that has a variety of repayment options. The most common repayment plan is a fixed amount per month for 10 years. But some lenders are also offering graduated plans that assume your child's income will rise the longer he or she is out of school. This plan allows your child to increase his or her monthly payment in two to three stages. And, with some lenders, students can consolidate their loans to increase the repayment time from 10 to, say, 20 years at a slightly higher interest rate.

All lenders will let your child defer payments if he or she decides to go back to school — they must be enrolled at least half time — or take up volunteer work. Unemployment, internships and fellowships may also entitle your child to defer. And all lenders are required to allow up to 24 months of hardship "forbearance."

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