A guide for student loans

Key takeaways

• Compare costs of different loan options.
• Look first at federal loans then consider state and private student loans.
• Borrowing from your home is also an option.

Every parent dreams that his or her child will strive for the "brass ring"—a college education that kick-starts a career and a promising future. But these days, that dream is at risk of being tarnished by America's student-debt crisis.

The average annual cost of a 4-year in-state public college, including tuition, fees, and room and board, is $20,770 for the 2017–2018 tuition year, and $46,950 per year for a 4-year private college, according to the College Board.¹ No wonder the average graduate in the class of 2016 left college with $37,172 in student loans.²

Important changes

For those borrowing for the 2017-2018 year, rates on federal Stafford loans (described below) for undergraduates have risen to 4.45% annually. Other recent changes, either as part of new legislation or because certain features were allowed to expire, include the following:

• Rates on future subsidized and unsubsidized Stafford loans will be set at 2.05 percentage points above the yield on the 10-year Treasury note, and capped at 8.25% for undergraduate students.
• Graduate students are no longer eligible for subsidized Stafford loans, and their rates for unsubsidized Stafford loans rose to 6% in 2017. The rate is based on the 10-year Treasury yield plus 3.6%, capped at 9.5%.
• Graduate students and parents of dependent children taking out federal PLUS loans will face stricter standards to qualify.
• Interest rates for parents and grad students taking out PLUS loans rose to 7%. Rates are now capped at 10.5%.
• In 2014, the White House expanded the eligibility criteria for the Pay as You Earn (PAYE) student loan repayment plan. For successful applicants, monthly student loan payments are capped at 10% of discretionary income.

What to do

"The key is to think ahead and figure out how much in college expenses you can afford," says Keith Bernhardt, vice president of retirement and college products at Fidelity.

Read Viewpoints on Fidelity.com: How much college can you really afford?

Once you have determined how much you can afford, focus your application process on colleges that fit your budget. Fill out the Free Application for Federal Student Aid (FAFSA) form to find out what grants, scholarships, and financial aid packages each college offers based on your family's expected contribution. Finally, compare total costs.

"If you need to borrow, look first at student federal loan options, because they generally have better rates and repayment terms," says Bernhardt. Also, consider looking at state-sponsored loans, or visit your state's higher education office. For a list of such institutions, visit Ed.gov.

Borrowing options

When shopping for federal student loans, keep in mind that there are 2 types—need based and non–need based. Federal Subsidized Stafford loans are need based. Federal parent PLUS loans and unsubsidized Stafford loans are not, although parent PLUS loans have eligibility restrictions. Consider each of these loan programs, as well as taking out a home equity loan or line of credit, if available (see chart below).

In financing your student's college education, it's important to shop based on a variety of factors, including loan availability, interest rates, loan terms, and flexibility of payments. For example, let's say you need to borrow $30,000. As you can see in the chart to the right, your interest rates and monthly payments can vary considerably—but so can the structure of your payments, including when you start and when the final payment is due, as well as your ability to qualify.

Federal loan options

Let's take a closer look at the options for federal student loans.

• Subsidized Stafford loans—Eligibility for these loans is determined by FAFSA. Typically, they are offered at set amounts for each school year—from $3,500 for the first year up to $5,500 in the third year and beyond—with a lifetime limit of $23,000. As of July 1, 2017, the interest rate is 4.45%. Interest begins accruing upon graduation or leaving school. Standard repayment is a 10-year term, but borrowers can apply for extended repayment options of 10 to 30 years, depending on the amount owed.
• Unsubsidized Stafford loans—To receive these loans, students must be enrolled in a qualifying degree or certificate program. Interest rates are 4.45% for undergraduate students for the 2017–2018 school year and 6% for graduate students, with extended repayment options of up to 30 years, though borrowers must apply and be qualified for extended repayment options such as income-based repayment. Loan limits vary from $5,000 to $12,500 a year for undergrads, with a lifetime limit of $31,000 for dependent undergrads and $57,500 for independent undergrads. Unlike subsidized Stafford loans, interest on the unsubsidized variety accrues from the time they are disbursed, rather than when the student leaves school.
• Parent PLUS and graduate student PLUS loans—These loans carry a 7% fixed rate in the 2017–2018 academic year and are available to graduate students and to parents of undergrads. Unlike Stafford loans, PLUS loans require underwriting, and standards have tightened. To qualify, recipients cannot have an adverse credit history, which includes bankruptcy and unpaid collection accounts and charge-offs. You can appeal a denial by providing added documentation or an endorser. Undergraduates whose parents are denied a PLUS loan are eligible for an additional $4,000 to $5,000 in unsubsidized Stafford loans a year. The bad news is that those who are denied a PLUS loan are unlikely to qualify for private loans. Loan terms can range from 10 to 30 years.

Beyond federal loans

Keep in mind that there are other college financing options beyond federal loans.

• Private student loans are available, but they typically carry variable interest rates as high as 12%, and they often reset each quarter. Unlike federal loans, most come with a repayment period of up to 20 years, versus 10 to 15 years for federal student loans. Private loans typically are stricter in their selection of borrowers as well. Your credit rate may cause you to pay a higher or lower interest rate, or be denied for a loan altogether. More than 90% of private student loans require a cosigner. Still, private student loans may be an option for some students, especially if they can qualify for a relatively low rate.
• State-sponsored student loans are loans that have your state's stamp of approval. These loans vary from state to state but in general are designed with the consumer in mind. Interest rates vary, but generally they range from 5.0% to 8.5%. Some states offer attractive features like interest rates that are fixed or the absence of tiered rates that are based on the borrower’s credit score.
• Home equity lines of credit or home equity loans are another popular option. Home equity lines of credit carry a variable interest rate recently averaging about 5.31%; the rate on home equity loans is fixed, averaging 5.31% as of December 2017, according to Bankrate.com. With the equity line, you have the flexibility to borrow money when you need it, and avoid paying interest on money you don't need yet. Home equity loans are generally given by a lump-sum amount in the beginning, and you will have to estimate all your future expenses at that time. However, with both a home equity loan and a home equity line of credit, you use your home as collateral, and risk losing it if you violate the repayment terms.
  
  Before December 2017, you would have been able to deduct the interest on home equity debt. That deduction has been suspended until 2025 as a result of tax reform, so one benefit of financing an education with home equity is off the table.

Tips for students

For students already enrolled in college or graduating with outstanding debt, here are some tips to understanding, managing, and paying off loans:

1. Understand the terms and conditions of your loans and be sure to meet your monthly payments.
2. Take advantage of private and government websites and resources; explore alternatives designed to lower payments, and tuition management assistance programs.
3. Check whether you qualify for a deduction of your student loan interest when doing your taxes.
4. Visit the National Student Loan Data System to keep track of your loans and financial services provider.
5. Opt to repay your student loans via automatic deductions from your bank account, which can help avoid penalties. Repaying student loans automatically not only avoids late fees but may also yield a slight interest rate reduction.
6. Pay off the highest interest rate loans first to save money in the long term.

Tips for parents

For parents, it's critical to make sure that helping their child pay the college tab won't shortchange their own home equity, retirement savings, or other short- and long-term financial goals. "Parents must do a trade-off analysis and remember they can borrow for college but not for retirement," Bernhardt suggests.

Considering the mounting burden of student-loan debt, most financial experts concur that the best way to reduce the burden is to launch a college savings strategy for your child as early as possible.

The good news is that there are tax-savvy accounts that can help you save. Among them:

• 529 savings plans, offered by states in conjunction with financial institutions, allow you to save after-tax dollars, but that money can grow tax deferred and be withdrawn federal income tax free to meet qualified education expenses. Up to $10,000 per beneficiary may be used for tuition expenses at public, private, or religious elementary and secondary schools in a calendar year, and although the money may come from multiple 529 accounts, the $10,000 limit is aggregated by beneficiary. Unlimited funds from 529 plans can be used to cover tuition, books, room and board, and fees at eligible college-level institutions and graduate schools nationwide. There is no annual contribution limit for 529 college savings plans except for the overall total contribution maximum, which varies by plan but is typically around $300,000. However, to avoid paying federal gift and transfer taxes, as an individual, you can contribute up to $75,000 per beneficiary by utilizing 5-year gift-tax averaging; or $150,000 for a married couple.³ (For a more detailed analysis, read Viewpoints on Fidelity.com: The ABCs of 529 college savings plans)
• Custodial accounts, either Uniform Gifts to Minors Act (UGMA) accounts or Uniform Transfers to Minors Act (UTMA) accounts, offer more investment choices but weigh more heavily on financial aid. They offer limited tax advantages, and the money saved becomes the child's at a certain age, regardless of whether he or she goes to college.
• Coverdell education savings accounts (ESAs) offer tax-free growth, can be used for college but also for primary education, and are designated for a child’s education expenses, but annual contributions are limited to $2,000 per beneficiary. Still, if you're contributing only $2,000 or less per year, these savings vehicles can be attractive, particularly because they offer a broad range of investment options. (Note: Fidelity does not offer Coverdell ESAs.)

In the end, the more you save, the less you have to borrow. You don't want your newly minted college grad trapped in a debt bubble that could limit his or her financial future.