You've heard the stories about students who borrow $40,000, $60,000, $100,000 to get a college degree and discover upon graduation that the monthly payments are way too high to manage. And then there are parents who stretch to the breaking point to send their kid to a school they can't afford.
Unrealistic expectations, and the thrill of acceptance letters, can impel families to make decisions that may not only hurt their children's future but also impair their own. According to a recent report by the Consumer Financial Protection Bureau, 10% of new grads have monthly loan payments that consume more than 25% of their income, and default rates have soared since 2008. Even more depressing, the New York Federal Reserve recently reported that more than two million people ages 60 and older are still paying down student debt.
You—and your kids—can avoid that fate if you steer clear of the mistakes that trip up families when they’re paying for college.
1. Don't wait until the financial aid awards arrive to decide which schools you can afford. Financial aid awards typically come with the acceptance letter or a week or two later. "By then, you've fallen in love with a place, and when you're in love, you make bad decisions," says Carol Stack, coauthor, with Ruth Vedvik, of The Financial Aid Handbook (Career Press). "Parents will raid their 401(k)s or say that they’ll get a second job."
SEE OUR SLIDE SHOW: 10 Best College Majors for a Lucrative Career
Instead, assess your ability to pay and your student's chances of getting financial aid while you're drawing up a college wish list. Start by estimating your expected family contribution—which schools use to determine financial need—with the calculator at the Department of Education's Web site. Then use the net-price calculator posted by each college you're interested in to see how much need-based grant aid each college is likely to contribute. Add those numbers; if the total doesn't cover the total cost, you'll have to borrow, kick in more from savings or your paycheck, or rely on merit aid.
You may still be confused about which schools offer the best financial aid package after you get the award letters. In July, the CFPB unveiled the Financial Aid Shopping Sheet, a standardized listing of tuition and other expenses, loans and scholarships that helps families compare financial aid awards. So far, about 200 schools have signed on to participate.
2. Don't count on a scholarship at your student's "reach" school. Colleges generally offer tuition discounts, otherwise known as merit scholarships, to applicants whose grade point average, test scores and other credentials put them in the top 25% of applicants. But with a reach school, your child is more likely to be in the bottom quartile of students accepted, who typically pay full price (minus any need-based aid). If you're counting on a discount, it's better to adjust your sights to colleges where your student will be within that top 25%. To find that match, compare your student's academic record with the freshman profile on college Web sites and talk to admissions counselors. "You want to know that the student will be happy and not getting in over his or her head academically, which can also mean financially," says David Hawkins, of the National Association for College Admission Counseling.
3. Don't assume that stretching for a prestigious school will pay off down the road. For a tiny percentage of students, that may be true. According to Payscale.com, which calculates the return on investment of more than 850 private and public colleges, students who attend top engineering, business or science programs, or an Ivy League school, generally reap the highest lifetime return on investment. Example: A student who attends Harvey Mudd College, number one on Payscale’s 2012 survey, pays $212,900 for a degree and earns a median total income of $1.467 million over 30 years. At Princeton (number five on the survey), a student pays $205,600; the median payback over 30 years is $1.163 million. But other distinguished schools cost as much as or more than those schools and deliver less than half the 30-year payback, reports Payscale.com.
As for the intrinsic value of the education, "there are so many incredible schools that are known regionally but not nationally. You need to find a school that will be the right match for your child," says Deborah Fox, of Fox Financial Planning Network, in San Diego. Choosing the right major and making the most of every opportunity have more impact on future earnings than a school’s prestige.
4. Never assume that your star student will get a full ride. If you match your student to a school that covets his or her exact qualifications, and if the school offers merit scholarships (most top-tier schools restrict their awards to need-based aid), you could land a deal that covers half or full tuition, plus any need-based financial aid.
Very few schools, however, offer merit scholarships that cover room and board, which runs an average of $9,000 a year at a public college and $10,000 at a private school, reports the College Board. And soccer-sideline conversations aside, only a tiny percentage of students receive athletic scholarships. The average amount, less than $10,000, usually doesn’t even cover tuition, according to Mark Kantrowitz, of Finaid.org. Where full rides do exist, your child will face stiff competition. (See this list of schools that offer full-tuition scholarships and those that offer full rides.)
5. Don't choose a private student loan over a federal loan because the rate is lower. Lately, advertised interest rates on private student loans have started as low as 2.25%. That looks good compared with the 6.8% rate on unsubsidized Staffords, the federally backed loans available to any student who applies, and even the 3.4% rate on subsidized Staffords, the comparable loans for students who qualify for financial aid.
But private student loans require underwriting and, generally, a cosigner. Only about 20% of applicants—those with credit scores over 770—get the lowest rate, according to Finaid.org. Some borrowers end up with loans that have rates well into the double digits.
And most private loans carry variable rates, not the fixed rates of Staffords and PLUS loans (the federally backed loans for parents). With rates currently at basement levels, the rates on variable loans have nowhere to go but up, and they will probably do so within two or three years, predicts Kevin Walker, of SimpleTuition.com, a student-loan comparison site.
A few lenders, including Sallie Mae and Wells Fargo, have introduced fixed-rate private loans in the past year or two. As with other private loans, the rate—which ranges from 5.74% to 13.75%—depends on how creditworthy the applicant is. To get a rate at the low end of the range, you’ll need a credit score of at least 725, says Walker.
There's one last, big reason to stick with federal student loans. "Private student loans lack the repayment options and borrower protections that come with federal student loans," says Lauren Asher, of the Project on Student Debt, an advocacy group. Such choices, including income-based repayment, let borrowers adjust their payments to their financial circumstances—a lifesaver for new grads who have yet to land a job or for workers in low-paying fields. With private loans, says Asher, you have no such flexibility. "The options if you hit hard times are very different."
6. Don't neglect to calculate how much your student can reasonably repay. You probably can't imagine any other circumstance in which you would let your kid borrow thousands of dollars without a discussion about what's involved. Yet many families do just that. For students, "it's easy to sit down at a computer, fill out a sheet and—bingo—they're committed," says Stack, the co-author of The Financial Aid Handbook.
Nor do families necessarily connect the loan amount with the ability to repay it. One rule of thumb is to limit the total to what the student can expect to earn in the first year after graduation. You can get a bead on that amount by researching starting salaries in your student's prospective field at Salary.com. Civil engineers, for instance, earn an average starting salary of $56,000. A community organizer earns an average of $32,011; a line cook, $21,903.
Stack and Vedvik use a different benchmark. They recommend limiting the debt to $32,000 (the maximum most undergraduates can borrow in Stafford loans, plus $1,000). Borrowers with $32,000 in loans at 6.8% will pay $368 a month over a ten-year repayment schedule—a doable, if not insignificant, amount. (For borrowing guidelines, see the table below.)
7. Never cosign a loan for your student to avoid borrowing in your own name. As cosigner, you put yourself equally on the hook if your student defaults—and defaulting can be a matter of missing just one payment. In that case, not only will your credit score go south along with that of your co-borrower, but you'll also be expected to make good on the debt. Most private loans won't be forgiven if your student dies or becomes disabled.
You can avoid these troubles by taking out a Parent PLUS loan, which requires a minimal credit check, carries a fixed rate of 7.9%, lets you defer repayment until six months after your student graduates, and offers several repayment schedules that will lower the monthly amount. It also discharges the loan if you or the student for whom you borrowed dies or if you become permanently disabled.
This article first appeared in Kiplinger's Personal Finance magazine. For more help with your personal finances and investments, please subscribe to the magazine. It might be the best investment you ever make.