I was attending a freshman orientation last summer, and sat in on the college financial aid presentation given by the school. During the Q&A session, one of the parents asked, “What type of debt or loans is best for parents to use in helping to pay for their child’s college?” This parent went on to explain, “Is it better to take a home equity loan, or a Parent PLUS loan, or some other type of private loan?”
The financial aid officer was right in responding, “Unfortunately, sir, we cannot tell you the answer to that question.”
The truth is, for many parents, their child/ren’s college education is probably the one of the biggest and most expensive family goals, next to their own retirement. And, since any one family is different than another with regard to income, assets, and number of family members… how you decide to finance college should be tailored to your individual needs, and not the needs of a another family (friends or even relatives) that may appear similar.
We’re going to discuss many of the most common choices available and that parent’s often consider. Some you may have thought of, and some of you may not have even considered. However, any funding that you consider should answer these four basic questions:
- How does it help or hurt us now?
- How may it help or hurt us in the future?
- How will it impact our potential financial aid?
- How will it impact my tax situation?
If you can answer these four questions in detail, for each of the funding choices that you would consider, you’ll be well on your way to making the smartest choices that may provide the best outcomes with the least financial strain.
Here are several of the funding options that many families will have available to them. We are not going to consider savings or investment options in this article, just debt/financing options. Because of the complexities of each type of debt, and how different financial situations warrant different considerations, this is simply an overview:
- Federal Student Loans: In general, federal student loans are a great option for many families. With the federal Stafford loan, for example, the student may qualify for government “subsidized” interest payments while they are in school, relatively low interest rates, and flexible repayment schedules. Parents benefit from the fact that they are not co-signers on the Stafford. There are other federal loans available, but most students qualify for a Stafford and are offered it as part of their financial aid package;
- State Student Loans: Many states offer their own financial assistance for collegebound students. I discuss the loans available through the State of New Jersey in my article about 12 NJ Grants, Scholarships and Loans to Help Pay for College;
- Private Student Loans: Most of these will require a co-signer (generally the parent), although some may release the parent at a future point in time (but not always!);
- Parent PLUS Loans: PLUS loans are actually federal loans for graduate and professional degree students, however, parents of dependent undergraduate students can also qualify. These loans are based on creditworthiness… so if your credit history is not good, you probably will not qualify.
- Personal Lines of Credit: This would be taken out by the parent. Generally the interest rates and terms are not favorable, compared to many of these other options;
- Margin Loans: Some families would like to tap the equity in their taxable investment portfolios and decide to utilize a margin loan to borrow against their investments rather than cash them out. Although margin loans often have favorable borrowing rates, a warning to the wise… borrowing on margin could lead to a potentially dangerous situation if the investment portfolio drops in value and could lead to something called a margin call, which may force you to deposit money into the account in a short time, or liquidate your investments during a period where your now leveraged portfolio has dropped significantly in value. In severe market corrections, I have seen investors wreck their entire portfolios by having borrowed too much on margin;
- Refinancing a primary mortgage: Depending on the family’s total financial picture, refinancing may make sense. If done with the right goals in mind from the outset, it could help them pay for college without sacrificing much in the way of current or future cash flow. However, done incorrectly, it is less effective and could extend the time to retirement for the parents;
- Second Mortgage/Home Equity: There are multiple ways to tap home equity. Some of these could actually lower the potential for financial aid from both the government and the college itself. Before you tap home equity to pay for college, I strongly advise that you consult a financial advisor who is experienced in college planning;
- 401(k) Loans: Why jeopardize your retirement by borrowing against your 401(k) to help pay for your child’s college? I’ve seen it done and caution strongly against it;
- IRA Distributions: Although an IRA is a savings/investment vehicle and not a debt, I mention it here because paying for your students college with your retirement funds is, to me, creating a debt against the parent’s retirement. Many times, parents will cash out part of their IRA to help pay for college without fully considering how that withdrawal will jeopardize their own retirement plan. The question whether to utilize an IRA is also different than discussing a 401(k) loan and is even further complicated when considering whether the IRA being tapped is a Traditional or Roth. After finding out whether your retirement planning is on course, and the extent to which an IRA distribution will affect the financial aid formulas, an IRA may be a viable alternative… but only after considering these factors;
- Cash Value Life Insurance (ex. Whole Life, IUL, etc.): Although you can borrow against the cash value of life insurance to help pay for college, there are many pros and cons to consider… a big one being that normally that amount “borrowed” is never actually paid back. So, understanding the design of your policy, how much you can borrow without imploding the contract, loan interest rates, and other policy features must all be considered. If you don’t have children yet, or they are very young, a properly designed CLVI policy that is designed to overfund the policy and “underfund” the insurance agent’s commissions (in my experience, one that is not traditionally presented by most insurance agents for that very reason) could potentially work very well as a college funding source. However, insurance company illustrations vary widely depending on how the policy is designed… even at the same insurance company. So, you want to utilize an expert who not only understands college planning, financial aid formulas and college funding… but one who you feel will help you create a funding vehicle and reduce their commissions to a level that help assure that it will work properly.
As you can see, there are often multiple options you may have at your disposal to help finance your child’s college education. However, with great choice comes great responsibility. You need to make sure that the option(s) you choose are the best for not only the student, but that they also fit into your own financial planning.
In a future article, I’ll discuss savings and investing options.
Interested in discussing how to pay for college without jeopardizing your retirement? I’d be happy to discuss funding options or even review funding sources you may have at your disposal (personal property, retirement accounts, life insurance, etc). Contact me or make an appointment online.