What’s the best way to pay for an expensive college?

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Q. My daughter is applying to colleges. She is insisting on a couple of expensive ones — we said we would pay for the equivalent of a state school — and she said she’s willing to take loans if she gets in. I know interest rates are bad. Might it make sense for us to take a HELOC and lend her the money rather than have her deal with higher interest rates?
— Mom

A. Congratulations on having saved enough money to pay for at least a big chunk of your daughter’s college education.

Deciding how to pay, when you need to borrow, can be tough.

Without knowing anything else about your personal and financial situation, we can’t determine whether borrowing money on a home equity line of credit (HELOC) to help pay for a more-expensive private school might make sense for you.

But you probably have better options, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.

Let’s start with a broader look at college financial aid, which comes in various flavors, including need-based aid, merit aid, grants and outside scholarships.

First, colleges determine your family’s eligibility for federal student aid based on your Expected Family Contribution (EFC), which is determined when you fill out the Free Application for Federal Student Aid (FAFSA) form, McGovern said.

Any need-based aid that your daughter is offered may include direct federal loans as well as work-study opportunities, which could reduce the amount of any borrowing needed, he said.

He said grants and merit scholarships are available at many schools, and outside scholarships are offered by numerous private organizations, foundations, corporations and individuals. Various federal and state government grants are also available. These don’t have to be paid back.

Free money is the best money.

“If you or your daughter do need to borrow money, it’s important to consider not only the loan interest rates but also other loan characteristics such as origination fees, whether the interest rate is fixed or variable, the loan term, how and when interest accrues on the loan, and the available repayment options,” McGovern said.

Loans for education are available from several sources, including federal loans, private loans, and loans from some state governments, McGovern said.

He said your daughter’s best option is usually direct federal loans, which are offered through the U.S. Department of Education. These come in two types—subsidized and unsubsidized. Direct subsidized loans are offered based on a student’s financial need. Direct unsubsidized loans aren’t based on financial need, he said.

“Direct federal loans, whether subsidized or unsubsidized, have several advantages over other loan types,” he said. “To begin with, the interest rate is fixed for the life of the loan, and students generally don’t need a credit check or a cosigner. The interest rate isn’t based on the student’s credit score or financial history.”

For direct loans first disbursed after July 1, 2022, and before July 1, 2023, the fixed interest rate for both subsidized and unsubsidized loans is just 4.99% for undergraduate students, along with an origination fee of 1.057%, he said.

New direct loan rates are set annually by Congress based on the last May auction of 10-year Treasury notes, plus a fixed mark-up rate, he said.

“While it’s possible that rates for 2023-2024 may go up this year, direct loan rates for undergraduate students are capped by law at 8.25%. New rates will apply to loans disbursed after July 1, 2023,” McGover said.

Repayment of all direct loans is suspended while the student is in school at least half-time, McGovern said. For direct subsidized loans, the government pays the interest that accrues during that period and for six months after school, he said. Interest on direct unsubsidized loans does accrue during college and must be repaid, he said.

“Unlike most private loans, direct federal loans offer great repayment flexibility, including the ability to postpone loan payments if the student is having financial difficulty,” he said. “Payments can be tied to the student’s income after school, and the loans can be forgiven entirely after 10 years if the student works for a nonprofit or government organization. Others can be forgiven after 20 or 25 years if loan amounts are still outstanding.”

Private student loans are available from private lenders, which offer both variable and fixed loan rates for terms of up to 15 years, and some feature forbearance protections from such adverse events as unemployment, McGovern said.

“Private loan rates can, however, be higher than those on federal loans, and the loans lack much of the repayment flexibility and options that come with direct federal loans,” he said. “Many private loans require a parent co-signer.”

Another option is federal direct PLUS loans, sometimes called Parent PLUS loans.

These are made to parents of undergraduate students, as well as to graduate students, and are limited to the total cost of attendance, minus any other financial assistance, such as direct loans, that the student receives, he said.
PLUS loans, however, can be expensive.

“Their current fixed interest rate is 7.543%, and the origination fee is a steep 4.228% of the loan amount,” he said. “PLUS Loans also are ineligible for most income-based repayment plans and lack much of the flexibility and protections of other direct loans.”

In New Jersey, what McGovern calls a “superior alternative” to PLUS loans and many private loans is available from the Higher Education Student Assistance Authority (HESAA).

HESAA offers fixed-rate “NJCLASS” family loans with 10-, 15- and 20-year options that have lower interest rates and origination fees than federal Parent PLUS loans, he said. Either the student or the parent can be the borrower.

Rates on these loans currently range from 3.75% to 6.75%, with 3% origination fees, depending on the loan term and when repayment begins, he said.

You can find more information about these loans, as well as about New Jersey grants and scholarships at hesaa.org.

Finally, you asked about a home equity line of credit (HELOC).

This is a type of revolving credit line, similar to a credit card, which allows you to borrow money against the equity in your home, McGovern said. A

HELOC generally features a draw period of 10 years, during which you can borrow up to your credit limit, followed by a repayment period that’s usually 20 years, he said.

How does a HELOC stack up for funding college costs?

On the plus side, a HELOC allows you to borrow only as much as you need, when you need it, at potentially lower interest rates than a private student loan or Parent PLUS Loan, McGovern said. During the 10-year draw period, you’re required to pay only the interest on the loan, so you have a lot of repayment flexibility, he said.

“However, borrowing against your house to fund your daughter’s education potentially puts your home at risk if you ever can’t repay the money down the road,” he said. “Moreover, depending on how much you borrow, and your total credit utilization, a HELOC has the potential to adversely affect your credit score.”

HELOCs also feature variable interest rates that are usually tied to an index, such as the Prime Rate plus a fixed mark-up. A variable rate loan for a potentially long time period puts you at risk of rising interest rates, such as we’re experiencing now, he said.

Some HELOCs do allow you to convert a portion of any outstanding variable-rate balance to a fixed rate. Nevertheless, right now, the Prime Rate is 7.5%, so the variable interest rate on a HELOC is likely to be in the range of 7.75 to 8% and will almost certainly go higher as the Federal Reserve continues to raise short-term rates in the near term, McGovern said.

By comparison, federal direct student loan rates for undergraduates are currently fixed at only 4.99%, and while they may go higher after July 1, they’re still likely to be less than the rate on a HELOC and can’t ever go higher than 8.25% under current law, he said.

Similarly, New Jersey’s HESAA loans, with fixed rates of 3.75 to 6.75%, currently feature lower rates than most HELOCs and won’t put your home at risk, he said.

“I your daughter is accepted at one of the expensive schools she’s interested in and decides to attend, your best option to fund the incremental cost is likely to be direct federal student loans,” he said. “If funds are needed beyond that, and assuming you live in New Jersey, consider a family loan from HESAA, which also features lower fixed interest rates than a HELOC or most other loan types right now.”

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This story was originally published on Jan. 24, 2023.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.