After a student reaches the federal student loan limits, parents can borrow to help their children pay for college through Federal Parent PLUS loans, private parent loans and by cosigning private student loans. These borrowing options, however, come with several potential pitfalls.
Higher Interest Rates
Parent loans are more expensive than federal student loans.
The interest rates on Federal Parent PLUS loans are higher than the interest rates on Federal Direct Stafford loans for undergraduate students, a full 2.55 percentage points higher. Federal Parent PLUS loans also charge loan fees of about 4%, compared with the loan fees of about 1% on Federal Direct Stafford loans.
A loan with 4% in fees is about the equivalent of a loan with no fees and an interest rate that is one percentage point higher, assuming a 10-year repayment term.
When Congress changed the interest rate formula on the Federal Parent PLUS loan in 2013, basing it on the last 10-year Treasury Note auction in May, plus 4.6%, with a 10.5% cap, they opened the door to price competition from private lenders.
Private lenders can offer private student loans and private parent loans with interest rates and fees that are competitive with the interest rates on Federal Parent PLUS loans, if the borrower or cosigner has excellent credit. This often requires a credit score of 780 or more.
However, Federal Parent PLUS loans offer superior benefits that may be lacking in private loans, such as death and disability discharges, longer deferments and forbearances, extended repayment and income-driven repayment, and loan discharge and forgiveness options.
But, private loans offer competitive interest rates only if you have an excellent credit score. If yours credit score is lower, or you have low income or a high debt-to-income ratio, you might be offered a much higher interest rate
Another consideration is the type of interest rate you’ll secure. The interest rates on federal loans are fixed, meaning they stay the same for the life of the loan, from your first payment to your last. But private loans may, more often than not, have a variable rate, which may fluctuate over time depending on market conditions. The interest rate may go down from time to time — but it may also go up, which can make payments more difficult to afford if you’re on a budget.
Risks of Cosigning
With all three types of loans – Federal Parent PLUS loans, private parent loans and private student loans – the parent is responsible for repaying the loan. This is unlike federal student loans, where only the student borrower is required to repay the debt.
All three types of loans will show up on the parent’s credit history and affect the parent’s ability to get new credit, such as a new credit card, auto loan or mortgage. Even if the parent can still qualify for a new loan, the interest rate may be higher due to a higher debt-to-income ratio or debt-service-to-income ratio.
Don’t forget that most parent loans involve a credit check, which can dent your credit score, whether you’re approved or rejected for the loan. Federal loans do not depend on your credit score, although the Federal PLUS loan bases eligibility on the absence of an adverse credit history.
But, with a private student loan, the parent is involved as a cosigner on the loan. A cosigner is not only obligated to repay the debt, but also may lack control over the debt. Many lenders send loan statements just to the student borrower and do not provide duplicate billing to the cosigner. The first sign of late payments might occur when the lender starts seeking payment from the cosigner or when the cosigner’s credit is already ruined.
Serving as a cosigner is not like supplying a credit reference. A cosigner is a co-borrower, equally obligated to repay the debt. Cosigning a loan is like giving the student the keys to your financial future. If you can’t get your child to clean up their room or finish their chores, what makes you think that they’ll manage their (and your) credit responsibly?
Borrowing Too Much Money
A student is unlikely to borrow more money than they can afford to repay using just the federal student loans. But, needing to borrow a parent loan or a private loan may be a sign of over-borrowing. This is especially true if the parent expects the student to repay the debt.
Generally, total student loan debt at graduation should be less than the student’s annual starting salary. It total student loan debt is less than annual income, a standard 10-year level repayment plan should be affordable. But, if total student loan debt exceeds annual income, the student will struggle to repay the student loans in ten years or less, and will need an extended or income-driven repayment plan to afford the loan payments.
Similarly, parents should borrow no more for all their children than their annual income. This will ensure that they can afford to repay the parent loans in ten years or less. If retirement is only five years away, however, they should borrow half as much.
The goal should be to pay off all debts, including parent loans, credit card balances, auto loans and mortgages, by the time you retire. Once you retire, there’s no new income, just fixed income, like Social Security retirement benefits, interest and dividends, and assets.
Limited Repayment Horizon
Federal student loans generally provide a choice of flexible repayment terms of 10 to 30 years — ample time depending on the plan, terms and loan amounts you select.
That isn’t always true for private lenders, who may offer just one loan term. If that term is just 5 or 7 years, the loan payments may be more than you can easily afford.
If that repayment term is 20 or 25 years, you’re stuck paying more interest in the long run. However, private student loans do not have prepayment penalties, so you could make extra payments to cut the effective repayment term.
What’s more, while a private parent loan has a forbearance option to temporarily put off payments, yours might only be up to one year, compared to the three-year maximum deferment/forbearance policy for federal student loans.
Limited Repayment and Forgiveness Options
Although income-driven repayment is available for Federal Parent PLUS loans, it is through an indirect narrow loophole that is limited to income-contingent repayment on Federal Direct Consolidation loans that repaid Federal Parent PLUS loans.
Private student loans and private parent loans generally do not provide income-driven repayment plans.
Federal Parent PLUS loans may be discharged upon the death of the student on whose behalf the loan was borrowed or upon the death of the parent borrower. Federal Parent PLUS loans may be discharged upon the total and permanent disability of the parent borrower, but not upon the student’s disability.
Only about half of private loans offer a death and disability discharge.
Federal Parent PLUS loans are not eligible for Teacher Loan Forgiveness. Except for Federal Parent PLUS loans that are repaid under income-contingent repayment, Federal Parent PLUS loans are not eligible for Public Service Loan Forgiveness. Military loan forgiveness and other loan repayment assistance programs may be limited to federal student loans and not available for federal parent loans.
Private loans are not eligible for any loan forgiveness programs.
Extended repayment is available for Federal Parent PLUS loans, but generally not for fixed-rate private loans.