Getting a college education is expensive, but the federal government can help with tax breaks for educational expenses, and being smart about managing your student loans can also cut your costs.
In this installment of Industry Focus, Motley Fool analyst Gaby Lapera and Director of Investment Planning Dan Caplinger discuss tax breaks for education, including the American Opportunity Tax Credit, the Lifetime Learning Credit, and the deduction for student loan interest. In addition, Gaby and Dan talk about consolidating student loans, which can reduce your monthly payment but risks losing some of the other benefits that various types of loans give you. Being smart about the implications of one choice over another is essential in order to make the most of your situation and not lose key advantages of the financial aid you've received.
A full transcript follows the video.
This podcast was recorded on Aug. 29, 2016.
Gaby Lapera: If you can have smaller loans, that's definitely the better option. Of course, talking about financial aid, I think we covered FAFSA, federal loans over private loans. The other thing to consider is scholarships. It's never been easier to find scholarships, which means it's also probably harder to get them, because so many people are applying for them. But if you go online and search for scholarships, I'm sure you can find something. I think they even give out a scholarship for being left handed. You have to apply, and I'm sure a lot of left handed people apply. But it's there. There's so, so many.
Dan Caplinger: Yeah, in all seriousness, it's a confusing thing that a lot of people get into trouble with. They see a size of a financial aid package, and they just compare it based on the size, and they don't look into how much of it is a grant or a scholarship that they just don't have to pay, versus how much of it is loans? And I've seen people make mistakes, and say, "This school gave me $40,000 and this other school gave me $30,000." But when you ask them how much of it was loans and how much of it was grants, it turns out that they would have been better off taking the smaller package because more of it was an outright gift that they would never have to pay back.
Lapera: Yeah. And I just want to take a moment to talk to college students out there. At the end of every semester, I would receive emails from students saying, "You can't give me a D, I'll lose my financial aid." And that always killed me because, I know there are professors out there who aren't great about helping, but I would literally meet you in a coffee shop, I would meet you after hours, I would give so much help. So, make sure that you do the work to get the good grades. Don't blow off the opportunity that you've been given, because you're making it very expensive for yourself.
After that heartfelt message, let's talk about taxes. (laughs)
Caplinger: The silver lining in all this is, the federal government understands how expensive it is to go to college. There are a number of tax breaks that a lot of people can take advantage of in order to reduce the cost, offset the cost, a little bit. Some of them hit while you're in school, others apply after you're through school trying to pay those student loans off.
Lapera: And the ones you get while you're in school are some of the biggest ones, correct?
Caplinger: That's right. Things like the American Opportunity Tax Credit, for up to four years of undergraduate education. That can often be the largest, because it'll pay 100% of up to $2,000 a year, then 25% of the next $2,000 a year. So, up to a maximum of $2,500 for a maximum of four years. Do the math, that's $10,000 toward your college education. Subject to income limits and that kind of thing, but it's readily available for a lot of people.
Beyond undergraduate, there's another credit called the Lifetime Learning Credit. It's not quite as generous, because it only applies to a smaller percentage of the amount that you pay. It's up to 20% of the first $10,000 that you pay for education over the course of the year. The benefit here is, it's not just limited to undergrad. It could be graduate school, it can be work training related, things that later in your career. The whole name of Lifetime Learning is design to emphasize just how much more flexible that is. Looking at those two credits, it can make a big dent in how much you're having to pay out of pocket, because the government is coming back and putting some back in your pocket.
Lapera: Yeah. I know that sometimes when people do their taxes, especially younger people, they look at them and they're so overwhelmed, they're just like, "I'm just going to take the standard deduction. I'm not even going to try to do any of these other things." But it can really help you out. Keep an eye out for that when you're filing your taxes this year.
The other thing we wanted to touch on briefly is, you have your student loans, you've graduated from college. Whatever is not eligible for forgiveness or whatever, you have to pay off. And sometimes people get overwhelmed with that. There are a few options you have if you are overwhelmed. First and foremost, I really encourage you to reach out to your creditors, because ultimately, it's in their best interest to get paid. They will work with you to help you make a payment schedule that works for the both of you, so you don't default and they don't get any money at all.
Caplinger: Yeah. It's in everybody's interest, it's in the creditor's interest to get some money back. Any arrangements that they can make that result in you making some payments is better than the reality of getting $0 back from you because you're just totally overwhelmed and can't afford to deal with it.
Lapera: Yeah. And then, the other thing I really encourage you to think about is debt consolidation, which is basically, they take all of your loans and bundle them. In theory, you can end up paying a lower interest on it afterwards.
Caplinger: Yeah. You have to be really careful with that, because there are reputable consolidation outfits, and there are unreputable consolidation providers. The real question that you have to look at very closely is what the makeup of your loans is currently. If you're heavily with private student loans, the consolidation is a lot more likely to make sense, because the private loans aren't all that good to begin with, so you don't really have a whole lot to lose with consolidation. When you have a lot of federal loans, however, you really need to look closely before you consolidate.
The questions you need to be asking the institution you're working with is, are you going to lose the benefits of these federal loans? Are you going to lose interest deferment? Are you going to lose the opportunity to have loan forgiveness? If the answer is yes, and you're in the category of people who would have taken advantage of those provisions, you're going to want to really think twice before you consolidate and give those up all in exchange for what can be a smaller monthly payment.
The other thing to look closely at is, most consolidation firms will offer you the smaller monthly payment. But what they don't really highlight is, the way they get you the smaller payment is often by extending the period of the loan a lot longer. So, I've seen situations where what would have been a five-year or a 10-year loan repayment period turns into a 20-year loan repayment period. And yes, you have smaller payments, but when you look at the total amount of interest you pay over the lifetime of your loans, it skyrockets after these consolidations, because you expended that period so much longer.
Lapera: Yeah, and part of the reason you could potentially lose benefits if you have federal loans is, because of the way consolidation works, it's basically a company buying your debt, and you promising to repay them rather than the original creditors. That's how you end up in these messes. You mentioned earlier that there's good consolidation companies and bad consolidation companies. Can you highlight what you should look for when you're looking for a consolidator?
Caplinger: One of the things that's ideal is, if you have a federal loan provider that you're already working with, the odds are much better that, if that federal loan provider reaches out to you to make consolidation recommendations, they're going to have the big picture there. Because they've already been vetted by the federal government to become eligible to give these federal loans. So, in general, they're a little bit more reputable.
On the other hand, if you're working with a private loan provider, they're always going to be looking for ways to get more of a loan balance under their umbrella, even if it's not necessarily the best decision for you. You can't have a blanket rule of, "All federal loan providers are good, all private loan providers are bad." Often, it's the same institution. But just being aware of the situation ... if you can sense that they understand the issues involved, that they understand that consolidation is not always the right answer, that's the best sign that you have that they're a provided that can give you the consultation that you really need to make the right decision for you.