1. Is it worth it to save for college?

2. If we do, are we penalized for saving?

The short answers are, 1) yes, and 2) maybe. The reason the answer to the first question is yes is that saving is better than borrowing, no matter what the circumstance. It is always better to have interest paid to you when you save money rather than to pay interest to someone else when you borrow money.

Let’s look at an example to help illustrate this point.

The Johnsons are savers. This family started saving for college when their son Timmy was five years old. They put aside $175 each month, which added up to $2,100 per year. After 13 years, they will have $27,300 saved. If their return is 5% per year, by the time Timmy is ready for college at age 18, they will have accumulated about $40,000.

The Baker family did not save any money for their children’s college educations. As their daughter Jennifer is about to start her freshman year, the Bakers look at how much of their income they can use to pay Jennifer’s college expenses. They decide they need to borrow $10,000 per year, or $40,000 total, assuming she finishes in four years and her expenses are the same each year. The interest rate is 6.8% with a 10-year repayment period. After Jennifer graduates, she gets a repayment schedule from her lender. Her total debt, including both the principal and the interest, comes to $55,238.

That $40,000 of borrowed money turned into $55,238 of debt.

It is clear with this comparison that the Johnson family made the wiser financial decision. For the same $40,000, they paid $27,300, while the Bakers will have paid more than $55,000.

Saving for college by itself is a good idea, provided the family doesn’t do it at the expense of maintaining normal living standards, putting aside money for emergencies and having an adequate retirement plan. Even without the comparison to borrowing student loans – remember, the $27,300 still turns into $40,000 – it is reasonable to measure saving against borrowing because loans are the primary means of paying for college in today’s world.

Assume that based on this information, we agree with the idea that setting aside an affordable amount each year makes sense. (Incidentally, it is wise to start saving for college when each child is born, but at least begin by age 8 so there will be 10 years of contributions and the accumulation of interest.)

Suppose that, over time, a family sets aside about $50,000 in a 529 plan. Based on the cost of college by the time the child enrolls as a freshman, it’s possible that this amount is not enough to pay all the college expenses, and it is necessary to apply for financial aid.

To go back to the second question, if a family does save, are they penalized for it? The answer is “maybe” because it depends on how the saving is done. If the $50,000 in the 529 plan is the only savings the family has, most of it will be protected from the calculation a school will make about how much a family needs to contribute. The “need formula” used by the federal government and the schools is the total cost of attendance less the amount the family can contribute. The difference is the need upon which financial aid is based. The formula includes an asset protection allowance so that the first $50,000 worth of savings in a 529 will not have an impact on the family’s eligibility for financial aid.

Assume the family has an additional $50,000 in savings or investments that maxes out the asset protection allowance. The $50,000 in the 529 plan is subject to the need formula and will increase the expected family contribution by about $2,500. If we assume that the $2,500 won’t need to actually be paid until well into the academic year, the family actually comes out even. Using a 5% return on the college savings, the family can earn back nearly the entire $2,500 in interest.

The bottom line is that the need formula will ask each family to contribute anywhere from zero to an amount that will need to be covered from the return on any college savings. In the end, that doesn’t seem like such a “penalty” for saving.

2. Review the fine print very carefully. Borrower Benefits sometimes have limits or restrictions. Make sure to speak with your lender and check your promissory note or promotional material for the details. Ask if there are ways the lender can take away the benefits (for example, if they sell your loan to another lending company).

3. Hold up your end of the deal. It is your responsibility to make sure you comply with the requirements of earning borrower benefits. The most common requirements are a certain number of on-time payments and automatic debit of your monthly payment (like using an auto-pay feature from your checking account). If you don’t do either, you could lose the borrower benefits and lose money in the process.

4. Set up auto debit from a checking or savings account for your monthly payment in the way the lender requires. This should be easy to comply with – don’t forget or you could miss the benefit.

5. Make monthly payments on time. Know how your lender defines “on time.” With some lenders, just being a day late could disqualify you from getting the benefit. This is part of the fine print you definitely need to understand.

Borrower Benefits are common on both federal student loans and private student loans, so it is worthwhile for you to do some research and shop around.

Most schools have excellent processes for helping students find the right loan or loans for their borrowing needs. After completing the FAFSA, or Free Application for Federal Student Aid, and any other forms that might be required by the school, the college or university will send the student a financial aid award package, outlining the type of aid being offered and how to apply for each kind.

After exhausting the “free money” part of the award – namely, scholarships and grants – and using the family’s allocated savings, investments or income to pay for college expenses, many students need to borrow money to make up the rest of the overall cost of college attendance. Students should always start with the federally-backed or funded loan types – such as Perkins, Stafford/Direct Loans, and PLUS loans for parents. All of these loans have fixed interest rates and lower (or no) credit score qualifications for borrowers.

That being said, most of these federal student loans have limits – students can only borrow specific dollar amounts depending on their need or their year in school. PLUS loans are the exception to this rule – but many parents decide they do not want loans in their name or they want the student to be responsible for repaying the loans after school.

After federal loans, the next option for students and their families are private (sometimes called “alternative”) loans. These loans are often seen advertised on television, in mailings, and on billboards. Private loans are backed by private banks, credit unions or other lending companies and often have competitive rates and “borrower benefits.”

With the exception of schools that participate in the Direct Lending program (where the loans come directly from the government through the school), colleges and universities frequently work with lenders to provide all of these loans to their students. When offered a choice among loan types or lenders, students and their parents often are confused or overwhelmed. Here are a few tips for making these decisions.

Know all of the loan options – It’s important to investigate many different loans before applying to get the best arrangement for each borrower’s needs. Be sure to shop around.

Look beyond the annual percentage rate (APR) – There are many other factors to consider, such as the total cost of the loan, deferment period, and the first payment due date. For federally-backed loans, the interest rate is fixed, but lenders differentiate themselves with borrower benefits that can bring down the total cost of the loan or the monthly payment.

Find a co-signer for private loans – Many students worry about not being approved for a loan because they do not have a co-signer. This is usually a hard and fast requirement for certain types of loans. A borrower may not be approved without one, especially younger students without credit histories. And, better rate / fee combinations are usually available only when applying with a credit-worthy co-signer.

Confirm loan details with the lender – It’s important to confirm interest rates, fees and other loan attributes, such as borrower benefits, with a lender before committing to the loan.

Pay attention to how and when the money is disbursed – Be sure to confirm if the lender sends the borrower the funds, or if they will go to the school directly. This is important because confusion over where the money has gone can delay settling your account. Also understand how long it will take to process a loan application. The turnaround time can vary between lenders and when students are up against due dates for tuition bills, this can make a huge difference.

Ask if the lender uses a “servicer.” A servicer is a separate company that handles the details of processing and collecting loan payments, customer service questions from borrowers, originating the loan, and more. Borrowers are often confused when they think they are taking out a loan from Company X, but then get paperwork from Company Y. Borrowers should communicate with the servicer and not the lender with questions, address changes or any changes to the student’s status.

Find out if the lender will capitalize the interest on the student loan. Some lenders will take the interest that is accrued when a student is in school and not making payments and add it to the principal, or the original borrowed amount. This usually only applies to unsubsidized federal student loans and private student loans. Capitalization increases the amount owed and the amount of each monthly payment. Some lenders capitalize the interest every three or six months, or once a year. The least expensive option is to find a lender who will capitalize the interest only once.

Learn about repayment assistance options. Look for a lender that will help manage your money with a variety of options for payment plans and repayment assistance. Graduated repayment is one option that means your monthly payments start out lower and increase as you earn more money. Forbearance is a deferment of your loan payments if you cannot make them, due to extenuating circumstances.

Choose a lender with good customer service. Remember that you are the customer here – in most cases, you have plenty of options from which to choose for a lender and student loans are a big commitment. Make sure to find a lender who you can reach with a toll-free telephone number or fast online assistance available 24/7.

We’ll try here to help you understand the many types of student loans available to families with some brief definitions.

Federal Loans

There are many kinds of federally funded and federally backed (or insured) student loans.

The Perkins Loan:

• Based on “exceptional” financial need and awarded at the discretion of the college or university. Schools usually have a fixed – and modest – amount that they in turn allocate to students. And note: many schools have no Perkins loans.
• Fixed 5% interest rate with no fees and a 9-month grace period (compared to 6 months on most other loan types). No interest accrues while the student is enrolled at least half-time.
• Maximum award of $4,000 per undergraduate year.

Stafford Loans

There are two ways to get the most common kinds of federal loans. The more common one is through the Federal Family Education Loan Program (FFLEP), which makes low-interest Stafford loans available to you or your parents. The government insures these loans and offers a variety of loan types and terms through private lenders, banks or credit unions. Some schools have “preferred lender lists” by which they recommend lenders with whom their students have had good experiences or who offer discounted rates or fees. However, as a borrower, you have the right to choose any lender you wish.

Federal Stafford Loans:

• Are borrowed through lenders.
• The student must be enrolled at least half-time.
• Interest rate is fixed at 6.8% with a 2.5% fee.
• Repayment normally starts six months after leaving school (or after changing enrollment status to less than half-time).

There are two types of Stafford Loans: subsidized and unsubsidized.

Subsidized Stafford

• The student and family must have financial need to qualify.
• Interest is paid by the federal government while in school at least half-time and during grace periods or deferments.

Unsubsidized Stafford

• Financial need is not required to qualify.
• Government pays no interest.
• The borrower can choose to pay the interest each month while in school or allow it to capitalize (be added to the loan principal).

Parent Loans for Undergraduate Students (PLUS)

In addition to other financial aid, parents of undergraduate students may be able to borrow a PLUS loan to help pay for school.

• The student much must be a dependent undergraduate.
• A credit check (looking at credit history and credit rating) is required.
• The student or family does not have to show financial need to qualify.
• Parents may borrow up to the total cost of attendance, minus any other aid received.
• The loan is not subsidized (the government pays no interest).
• Repayment normally starts 60 days after full disbursement of the loan. However, some lenders may allow borrowers to defer payments while the student is enrolled or if the parent is enrolled in school, too.

Federal Direct Loan Program

Your school might participate in the Direct Lending program. These schools have chosen to offer student loans directly to families from the government, without using a bank or private lender. The loans are repaid directly to the federal government and will never be sold to another lender or bank. Direct Lending schools can offer Stafford and/or PLUS loans. Eligibility, interest rates and borrowing limits are the same as for FFELP loans. You have a choice of four repayment plans, with slight term variations from those offered by the FFELP.

Regardless of the type of education loans you and your family decide to use to finance your college education, they all have to be paid back with interest. Keep in mind the total cost of the loan as well as what the monthly payment will be when you enter repayment. Make sure to budget for these loan payments!