The ABCs of interest-free college loans

These loans typically aren't designed to cover the entire cost of college, but for some students, they could be a good way to fill funding gaps.

  • By Cheryl Winokur Munk,
  • The Wall Street Journal
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When it comes to paying for college, interest-free loans often fall under the radar. But for some students, they could be a viable alternative to costlier private student loans.

Interest-free loans tend to be for smaller amounts, so they aren’t meant to cover the entire cost of college. They may, however, be useful for students who have exhausted opportunities for scholarships and grants and have reached the annual borrowing limit for federal student loans. For dependent students, that limit is $5,500 for a first-year undergraduate, $6,500 for a second-year undergraduate and $7,500 for a third-year undergraduate and beyond. (Students who are considered independent for financial-aid purposes have higher limits.)

After tapping these resources, students who need more funding often turn to the private loan market, where loans can carry hefty interest rates. Credible.com, a student-loan marketplace, highlights rates from multiple lenders in the range of around 4% APR (annual percentage rate) to around 14% APR, depending on factors such as the lender, the borrower’s creditworthiness, the length of the loan and whether the interest rate is fixed or variable.

With an interest-free loan the student pays back exactly what he or she borrows.

“A scholarship is always best because it doesn’t have to be repaid, but students who have a gap should be on the lookout to see if interest-free loan opportunities exist within their community,” says Michele Waxman Johnson, vice president at Central Scholarship, an Owings Mills, Md.-based funding provider for postsecondary education whose offerings include interest-free loans.

Who offers them

Generally, interest-free loans are offered through local associations, religious organizations, charities and foundations and are often geared toward borrowers with considerable financial need. A number of programs are rooted in the Old Testament’s prohibition against charging interest on loans.

Loan amounts, eligibility requirements and repayment terms vary by program. For example, one loan program might offer a loan of only $1,000, while another might offer as much as $15,000 a year. Some programs have state or local residency requirements, some are available only to undergraduate students, and others are linked to a student’s ethnicity or a parent’s military service. Most times, a guarantor or multiple guarantors are required.

Because the programs vary so widely, students need to read the fine print to ensure that they qualify and are likely to be able to satisfy the repayment terms. “You have to do your due diligence,” says Ross Riskin, assistant professor of taxation and CFP program director at the American College of Financial Services.

Interest-free loans don’t offer the same types of borrower benefits and protections that federal loans do, so students shouldn’t seek to replace a federal loan with an interest-free one, says Will Sealy, co-founder and chief executive of Summer, which advises borrowers on the student-debt repayment process.

Federal loans, for example, offer income-driven repayment options. Federal-loan borrowers may also be eligible for other career-specific forgiveness opportunities such as public-service loan forgiveness or teacher loan forgiveness.

Not as flexible

Borrowers also should be aware that some repayment terms for interest-free loans may not be as flexible as those for other private loans. Some interest-free loan providers, for example, require borrowers to start making payments while they are still in school; others give borrowers fewer years to repay the loan. Also, some interest-free loan providers have graduated repayment plans, meaning borrowers make higher payments as time goes on, based on higher salary assumptions. Students considering an interest-free loan should be sure to inquire about any flexible repayment options that may exist.

While students can save money by using interest-free loans, they can end up in a bind if they can’t pay them back. “Unfortunately, with private loans there are very few options if you can’t pay your loan,” Mr. Sealy says.

Finding relevant interest-free loan opportunities can take some legwork. Students can speak to the financial-aid office at their prospective schools, local religious and community organizations, high-school guidance counselors, the agency in their home state responsible for higher-education access and search online to help uncover these opportunities.

Students also can visit the International Association of Jewish Free Loans’ website at iajfl.org/for-borrowers to find programs that may be applicable to them in their local area. Other options for interest-free loans include the Bill Raskob Foundation, open to any U.S. citizen after their freshman year, and the Evalee C. Schwarz Charitable Trust for Education, for undergraduate and graduate students who demonstrate exceptional academic performance and significant financial need.

For military families, the Military Officers Association of America offers educational assistance to military families, and the Leo S. Rowe Pan American Fund provides interest-free loans to individuals from Latin America or certain Caribbean countries who will be completing professional, graduate or the last two years of undergraduate studies at eligible institutions.

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