Parents start worrying about how to finance their child’s college education in the spring. Their child has received one or more offers of college admission and has chosen a college. Now, they need to figure out how to pay for it.
But, parents who don’t have any recent experience paying for college often make several mistakes.
These are some of the most common mistakes parents make.
Failing to Consider Financial Fit
The student chooses a college without knowing whether their parents have enough money to pay for it. They want to go to the college with the best reputation, which may also be the most expensive college. They don’t consider whether the college is affordable.
This is like buying a Lexus when all you can afford is a Yaris.
Families need to consider financial fit in addition to academic fit, social fit and environmental fit. The child’s dream college isn’t always a college that fits the parents’ budget. Just because you want something doesn’t mean you can afford to pay for it.
The net price is one metric of financial fit. The college’s net price is the difference between the college’s cost of attendance and the gift aid awarded to the student. Total college costs include housing, meals, books, supplies, equipment, transportation and miscellaneous personal expenses in addition to tuition and fees. Gift aid includes grants, scholarships and other money that does not need to be repaid.
You can estimate the four-year net price by multiplying the one-year net price by four, adding in a 10% buffer for inflation, and adjusting the result if the college practices front-loading of grants. (More than half of colleges practice front-loading of grants.)
Compare the four-year net price with total family resources available to pay for college, including college savings, contributions from income and a reasonable amount of student loan debt. If the net price is more than total family resources, the college is unaffordable. If the child enrolls at this college, they, and their parents, will have to borrow an unreasonable amount of student loan debt.
Failing to consider financial fit can lead to over-borrowing, where the student graduates with more student loan debt than they can afford to repay. Parents too may sacrifice their financial future by piling on parent loans.
Choosing Too Expensive a College
It is shocking how often parents think that $50,000 in student loan debt for one year of college is reasonable and affordable. That’s too much debt for an entire education program, let alone for just one year. Borrowing $50,000 per year will yield more than $200,000 in student loan debt by the time the child graduates from college.
Sometimes, the prospect of borrowing that much debt just doesn’t seem to faze the parents, even as they say that they can’t afford to contribute much to help their child pay for college.
They need a reality check. They need to consider how the student loan debt will affect their child after they graduate from college, if they graduate from college. They need to hesitate and think twice before mortgaging their child’s financial future.
If total student loan debt at graduation is less than the student’s annual starting salary, they can afford to repay their student loans in ten years or less. Otherwise, they will struggle to make the student loan payments. They will need an extended or income-driven repayment plan. These repayment plans reduce the monthly student loan payments by increasing the repayment term to 20, 25 or even 30 years. It will take them at least half the time from graduation to retirement to repay the student loan debt, if not longer.
The average starting salary for a Bachelor’s degree is about $50,000. Depending on the academic major, it can be higher or lower. Arts and humanities majors tend to earn less, while science, mathematics, engineering and healthcare tend to earn more. Use the College Scorecard website to look up the median earnings 10 years after graduation from each college. Don’t borrow more than half this figure.
Instead of enrolling in a high-cost private college, the student should consider enrolling in an in-state public college, which will cost a quarter to a third the cost of a private college, even if they get no financial aid.
Choosing a Student Loan Too Quickly
Parents often feel time pressure to find a student loan quickly. They want to find a fixed-rate student loan before interest rates rise too much.
The time pressure sometimes causes them to overlook some of their lowest-cost options. Don’t get locked into a loan before you learn about the interest rates on federal student loans and federal parent loans.
For example, federal student loans and federal parent loans have a fixed interest rate for the academic year that is set on July 1, based on the last 10-year Treasury Note auction in May.
If the family rushes to choose a private student loan soon after the child has chosen a college, they may miss out on some of the lowest-cost student loans. Federal student loans are often less expensive than private student loans, and provide more flexible repayment terms.
Don’t let time pressure force you into a hasty decision.
Failing to Shop Around for the Lowest-Cost Loan
The loan with the lowest advertised interest rate is not necessarily the best loan for you.
Your actual interest rate may be much higher. You have to apply for each loan to learn the interest rate you will actually pay.
The interest rates on a private student loan are based on the credit scores of the borrower and co-signer. A better credit score yields a lower interest rate. But, each lender has its own mapping from credit scores to interest rates. This can lead to big differences in the interest rates you are offered. Even a slight improvement in your credit score may yield a much lower interest rate, due to cliff effects in the way that lenders tier their interest rates.
Ignore all the double talk about interest rate indexes.
Lenders often tie their interest rates to a variable-rate index, such as the London Interbank Offered Rate (LIBOR) index, Secured Overnight Funding Rate (SOFR) index and Prime Lending Rate, plus a fixed margin based on the borrower’s and cosigner’s credit scores . Even fixed-rate loans are tied to a variable-rate index, but at a particular point in time. The LIBOR and SOFR indexes are lower than the Prime Lending Rate.
The choice of a particular index rate doesn’t matter much, since lenders that use a lower index tends to add higher margins to the index. They adjust the interest rate according to the spread between the two indexes.
The various indexes tend to change at the same rate when prevailing interest rates change. The only difference is that some lenders base their interest rates on a one, three or 12-month average of the index, to smooth out volatility. A longer time period for the average effectively phases in interest rate increases more slowly.
What really matters is the actual interest rate you are offered, not the index upon which it is based.
Carefully consider the difference between fixed and variable interest rates. A variable interest rate may initially be lower than the equivalent fixed interest rate. But, in a rising rate environment, a variable rate has nowhere to go but up. A variable-rate loan should be considered only if you are capable of paying off the loan in full before interest rates rise too much. Otherwise, you may regret agreeing to what is really a teaser rate.
The interest rate on a fixed-rate loan will also depend on the length of the repayment term. The lowest interest rates will often require you to agree to the shortest repayment term, as short as 5 or 7 years. Lenders will not allow you to increase the repayment term later, as their cost of funds increases with a longer repayment term. If you later choose to refinance the loan to get a longer repayment term, you may have to pay a higher interest rate then than you might have received now.
Loan costs include not just the interest rate, but also the fees and discounts. Fees are like up-front interest that increase the cost of the loan. You pay the fees even if you decide to pay off the loan early. The fees on the Federal Parent PLUS Loan, slightly more than 4%, is about the same as a 1% higher interest rate with no fees on a 10-year repayment term.
For example, the new fixed interest rates on federal relative loans for 2022-23 are likely to be around 7.5% plus about a 4% fee. (The interest rates and fees on federal student loans are lower.) The equivalent no-fee interest rate is about 8.5%. Parents who have excellent credit might qualify for a lower fixed rate on a private student loan. But, a federal parent loan may be less expensive for many families. So, don’t sign up for a private loan before you’ve explored all of your options. Use a student loan calculator to compare the monthly loan payments and the total payments over the repayment term.
When considering the impact of student loan discounts, focus on just the discounts that you are likely to qualify for. Many lenders offer a 0.25% or 0.50% interest rate reduction if you agree to make the payments by automatically transferring the money from your bank account. But, some borrowers feel uneasy about AutoPay because it feels like the lender is reaching into your bank account to take the money. That really isn’t true, as you remain in control, but some borrowers miss out on the discounts because they ultimately don’t sign up for AutoPay.
Applying for several private student loans will not have a big impact on your credit. Credit reporting agencies are able to recognize shopping-around behavior if you apply for several student loans within a short time period. There will be just one hit to your credit score, as opposed to multiple hits. The typical impact is less than a 5-point reduction in your credit score, and it is usually temporary.
Also, some lenders and student loan marketplaces use a soft credit inquiry when determining interest rates, using a hard credit inquiry only when the borrower has decided to get the loan. A soft credit inquiry does not affect your credit score.
Be careful about using student loan marketplaces, which list loans from multiple lenders. They are usually pay for play, meaning that they only list lenders who pay them for a referral. Other lenders that aren’t included in the marketplace, such as state loan programs, may offer lower interest rates.
Not Checking Your Credit Before Applying for a Private Student Loan
Because eligibility for a private student loan, and the interest rates, depend on your credit scores, it is important to review your credit history for errors before applying for a private student loan.
Get a free copy of your credit reports from annualcreditreport.com at least a month before you plan on borrowing. Review the credit reports for errors.
You can get errors corrected by disputing the incorrect information. The creditor then has 30 days to either confirm the accuracy of the disputed information, or remove it from the credit report.
Inaccurate information can affect your credit scores, so correcting inaccurate information can yield a higher credit score.