A Parent's Complete Guide to Student Loans

Image credit: Getty Images

Image source: Getty Images

Student loans are a necessary evil for most young adults, and parents often help shoulder the burden. It's an admirable decision, but it's not one you should make lightly. Once you've signed a parent student loan, there's no going back. You could spend the next decade or more paying back what you borrowed.

If you're determined to help your child pay for his or her college education, do your homework to make sure you get the best deal. The wrong choice could leave you or your child with an unaffordable loan that tanks your credit score and threatens your financial security.

Here's everything you need to know to help you choose the best option for you and your child.

How student loans work

Traditional student loans are taken out in the student's name, and they come in two types: federal and private student loans. Federal student loans are also known as Direct loans. They’re issued by the federal government and they're the first stop for most students after financial aid and scholarships. Private student loans are issued by private lenders, and terms vary widely depending on the lender.

Federal student loans don't require a cosigner, but students can only borrow so much per year. The amount varies depending on their year in school and whether they're a dependent or independent student. Independent students are

• 24 or older,
• married,
• a graduate or professional student,
• a military member or veteran,
• an orphan,
• a ward of the court,
• an emancipated minor,
• responsible for dependents of their own,
• homeless, or
• at risk of being homeless.

These students can borrow more than other dependent students. Dependent students whose parents are ineligible for a parent Direct PLUS loan also have higher borrowing limits (more on that below). Here are the 2019 borrowing limits:

Data source: U.S. Department of Education.

Federal loans offer affordable rates with few eligibility requirements. They also have flexible repayment options like income-driven repayment. Deferment and forbearance are also available during financial hardship. Theses options temporarily stop your student loan payments if students have trouble repaying.

If federal student loans, scholarships, personal savings, and financial aid aren't enough to cover the full cost of attending college, students turn to private student loans.

Private student loans typically have stricter eligibility requirements. They may require the student to show a certain level of income or credit score to be approved. They also have fewer repayment options and few opportunities for deferment or forbearance.

On the upside, the amount you can borrow is limited only by your credit and the cost of attendance at your school. Most borrowers can get far more in private student loans than they can in federal loans.

How parents can help children with student loans

As a parent, you have three options for helping your child with student loans.

First, you could cosign a private student loan in your child's name. This may be the only way your child can get a private student loan on his or her own. Private lenders often expect to see a credit score or a level of income that most college students don't have because they've yet to begin their careers and haven't been using credit for long.

When you cosign a loan with your child, you're essentially vouching for their credibility. Your child is primarily responsible for the loan, but if he or she is unable to keep up with the payments, you will have to make the payments. If you don’t, your credit score will take a hit along with your child's.

Cosigning a private loan isn’t a good idea if you doubt your child's ability to make the payments. It may also be a poor fit if you’re hoping to minimize the debt your child takes on because he or she is still responsible for the payments.

Second, you could take out a Parent Direct PLUS loan. This is a federal student loan issued to parents. It's similar to the Direct PLUS loans issued to graduate students. These parent student loans are in your name, not your child's, and you are responsible for paying back the borrowed amount.

To qualify,

• you must be the biological or adoptive parent of a dependent undergraduate student,
• the student must be enrolled at least half-time in a qualifying institution, and
• you must not have an adverse credit history.

If you do have a bad credit history, you may be able to get approved with a cosigner. You and your child must also meet general federal student aid requirements, like being a U.S. citizen or permanent resident and completing the Free Application for Federal Student Aid (FAFSA).

Federal student loan terms are the same for every borrower. Parent Direct PLUS loans issued before July 1, 2019, have an interest rate of 7.6%. The rate is fixed for the lifetime of the loan. This is higher than the interest rates on other types of federal student loans, which currently range from 5.05% for Direct student loans to 6.6% for graduate Direct PLUS loans. You can borrow up to the full cost of attendance at your child's school, minus any other financial assistance your child receives.

Parent Direct PLUS loans offer more flexible repayment terms than private student loans, but fewer than Direct loans for students. You can choose from the following options:

• Standard repayment plan: You pay a fixed monthly amount every month for 10 years.

• Graduated repayment plan: You still pay off your loan in 10 years, but your payments start lower and increase every two years.

• Extended repayment plan: You pay a fixed or graduated amount for up to 25 years. This approach costs more overall.

• Income-contingent repayment (ICR) plan: You must consolidate your Direct PLUS loans in order to become eligible for ICR. Your monthly payment will be the lesser of 20% of your discretionary income -- the difference between your income and the poverty guideline for your state and family size -- or the amount you'd pay on a fixed 12-year repayment plan. Payments are recalculated each year based on income and family size.

If you have trouble keeping up with your payments, you may be able to request forbearance -- a temporary halt in your payments -- while your child is in school and for six months following graduation. This is only for use if you're experiencing temporary hardship.

The federal government may also forgive some of your student loan debt if you

• work for a nonprofit or other qualifying organization for 10 years,
• make 120 on-time payments, and
• fill out the appropriate paperwork every year.

Third, you can seek out a parent student loan with a private lender. This type of loan is less common than private student loans, so you may have to do some research to find lenders that offer it.

Unlike federal loans, offers from private lenders will differ and vary based on your income and employment history, credit score, and debt-to-income (DTI) ratio. DTI is a measure of your monthly debts compared to your monthly income. Ideally, your monthly debt payments shouldn't exceed 35% of your monthly income. If they do, lenders could be hesitant to work with you.

Individuals with a credit score of 700 or above will qualify for the best rates. That could make a private parent student loan more affordable than a Parent Direct PLUS loan.

Be mindful of the interest rate you get. Private lenders may offer fixed student loans -- where the interest rate remains the same over the lifetime of the loan -- or variable student loans. Variable student loans often start out with a lower interest rate, but they can rise over time. If they do, your payments will grow and you could pay more overall.

Some private student loan companies give you a choice of repayment plans or offer deferment or forbearance, but this is up to the lender. If you question your ability to pay back your student loans, you could be at risk of default. You may be better off sticking with a Parent Direct PLUS loan so your repayment terms are more flexible.

If you decide to go with a private student loan -- either cosigned with your child or in your own name -- shop around for the best offer. Pay attention to the interest rates, repayment terms, fees, and opportunities for deferment or forbearance. Don't hesitate to reach out to the lender if there's anything you don't understand. You want to know exactly what you're signing up for.

Consolidating and refinancing student loans

If you or your child takes out multiple student loans, it's possible to consolidate them into a single, new student loan so you have one monthly payment instead of several. However, it's not possible to transfer ownership of the loan from parent to student or vice versa through consolidation.

You can consolidate federal Direct loans, including Parent PLUS loans, into a Direct Consolidation Loan. Rates depend on the interest rates for new federal student loans when you consolidate. If you hope to take advantage of income-based repayment plans, you must consolidate your federal student loans first. Private lenders may also enable you to consolidate your student loans if you have several loans in your name.

Another way to reduce how much you owe is to refinance your student loans. There's no way to refinance a federal student loan with a new federal loan. You must work with a private lender.

Think carefully before doing this. If you go this route, you give up the flexible federal student loan repayment terms and the opportunity for student loan forgiveness. If you refinance existing private student loans, this won't be a concern.

When you consolidate or refinance a student loan, any outstanding interest on your loan becomes part of the principal balance. Your principal balance dictates how much you pay in interest each month, so by raising your balance, you could end up paying more overall. Your lender may also charge you fees if you consolidate or refinance your loans. Check with the company to learn about upfront costs associated with your new loan.

Parents and students have a lot of options when it comes to paying for college, but it's not always clear what the best option is. Students should always start by applying for scholarships, grants, and financial aid.

After that, it's up to you and your child to decide your next move. If you're comfortable taking full responsibility for the cost of some of your child's education, take out a parent student loan. If not, help your child secure a loan if he or she cannot do so without a cosigner.

Whichever route you go, make sure you understand the terms you're signing up for and your options if you have trouble keeping up with the payments.