Parents should beware of borrowing too much to pay for children's college education
April 23, 2013 8:00 AM
By Tim Grant Pittsburgh Post-Gazette
Faced with rising college costs and a shortage of savings, many parents are making difficult decisions about whether to borrow money to help fill their children's college funding gap at a time when they themselves are approaching retirement age.
Taking out loans may be inevitable in some cases, even if parents have been putting money away and their children have received grants and scholarships. But the decision to go into debt could have ripple effects on parents' financial security.
"Before parents borrow for college, they should look at their own financial big picture," said Stephen Talbott, author of the e-book, "How Much Should I Borrow for College?" "They need to ask themselves how far along they are saving for their own retirement, and are they putting in enough to be comfortable when they are 75 or 80 years old?"
Although a recent study by private student loan lender Sallie Mae found parents are footing the bill for a smaller share due to more students stepping up to the plate, many parents will do whatever it takes to give their children the best head start possible -- even if it means borrowing more than they should.
Borrowing programs designed to help parents raise money for their children's education -- such as PLUS loans -- could potentially hurt the families they are intended to help. The loans are remarkably easy to get, yet nearly impossible to get out from under when families bite off more debt than they can chew.
Unlike federal student loans, PLUS loans -- which also are provided by the federal government -- have no limit on borrowing. Parents can borrow as much as they need to cover their child's education up to the full cost.
But like all student loans, PLUS loans are next to impossible to discharge in bankruptcy. The government can seize tax refunds and garnish wages and Social Security checks if parents default.
While the government does check parents' credit history, PLUS loans are typically approved as long as there is no recent adverse information on the credit report, such as bankruptcy or foreclosure. But there is no assessment of the borrower's income, employment status or what other debt could affect the ability to repay.
Mr. Talbott said parents can do their own rough calculations of how much room they have to borrow from PLUS loans by assuming that their total debt payments should not exceed 35 percent of their monthly income -- a standard measure.
"Add up your mortgage or rent payments plus car and credit card payments and do the math," he said. "The rule of thumb says that -- if you are under 35 percent -- the difference between what you are now paying and the 35 percent level is what you can afford to borrow for college once you divide the amount into monthly payments."
Some parents may choose to help their children by co-signing their college loans.
While federal student loans do not require co-signers, private student loans often require students to have their parents co-sign. But saying yes could have the lender coming after the parent if the child cannot repay.
"Parents co-signing for the child is dangerous as the loan obligation becomes the parents' if the child defaults or dies, and student loans are not discharged in bankruptcy," said Robert Fragasso, chairman and CEO of Fragasso Financial Advisors, Downtown.
Borrowing for education expense will only increase the financial strain on families because interest costs are now added into the mix. "This is true no matter what the source of borrowed funds," he said. "However, if borrowing is the only way, using a home equity line of credit at least causes the interest to become tax deductible."
Mr. Fragasso said rearing children costs more than $400,000 without considering college expenses, which can double that cost or increase it by at least 50 percent.
Grandparents face the same set of problems -- running out of assets or having insufficient income during retirement. But wealthier grandparents may be more able to shoulder the cost burden than parents who are still struggling to accumulate assets. The estate tax code also can help grandparents make gifts to a student or make direct payments to the institution.
Families will need to fill out a FAFSA application (Free Application for Federal Student Aid) to qualify for most forms of financial aid, including federal grants, federal loans and scholarships. The FAFSA consists of about 130 questions that help the U.S. Department of Education evaluate a family's financial situation to determine how much assistance they need.
"Parental borrowing is likely not the best option because of the place in life that parents with college-aged children usually find themselves -- nearing retirement," said Brooke Anderson, a senior tax manager at the Alpern Rosenthal accounting firm, Downtown. "Keep in mind that there is no FAFSA-like application to pay for retirement.
"As such, parents who intend to retire should continue to save for that life stage, rather than redirect funds to the payment of educational expenses."
Lender Sallie Mae found in a study that the debt burden on parents has declined in recent years due to students paying a higher portion of the college bill.
Students are paying 30 percent of the total bill, up from 24 percent four years ago, while parents are paying 37 percent, down from 45 percent four years ago.
Students also paid more out-of-pocket through their savings and income, contributing an average of $2,555 in 2012 (up from $1,944 in 2009) and borrowed $3,719 (up from $2,721 in 2009), according to Sallie Mae.
There are other options for finding money beyond federal and private loans. Most 401(k) plans allow workers to borrow half the funds in their accounts up to $50,000, and parents routinely borrow from their 401(k)s or withdraw from their IRAs for college tuition and other costs.
But financial advisers for the most part discourage both.
While the money belongs to the parents, they must still pay it back with interest -- usually the prime rate plus 1 or 2 percentage points. When parents borrow from a 401(k) to pay for college expenses, it has no impact on a student's eligibility for need-based financial aid. But the borrowed money will lose its ability to compound in the account until it is paid back.
Also, if the parent leaves his or her job because of resignation or termination, the 401(k) loan must be repaid in full within 60 days or it is taxed at the parent's ordinary income tax rate and a 10 percent penalty will apply if the parent is less than 59 1/2 years old.
If money is withdrawn from an IRA to pay for qualified educational expenses, the withdrawal is exempt from the 10 percent penalty which usually applies to withdrawals made before age 59 1/2.