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The ABC's of Student Loans — From Applications to Repayment Terms

What you need to know before you borrow

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You've decided that returning to school is the best way to enhance your value to your current employer, or to find a new job or even a new career. To finance this move, you'll simply take out a student loan.

Nadine Burns wants to talk you out of it. The certified financial planner (CFP) at A New Path Financial Services in Ann Arbor, Michigan, agrees these loans may be the easy way to finance additional education, but you should think of other ways as well. “A prime reason not to take out a student loan is they cannot be [easily] bankrupted. Instead, look for grants, scholarships or even a second job to cash-flow the degree before reentering school."

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She's right. In fact, you must fill out the Free Application for Federal Student Aid (FAFSA) to be notified about eligibility for grants and work-study — in addition to student loans. If a loan is part of your financial aid package at your school, then you can apply for one from the government or from a private financial institution or organization — though federal loans tend to offer more flexibility and benefits.

A. Borrowing from Uncle Sam

Each year, the office of Federal Student Aid, part of the U.S. Department of Education, provides more than $120 billion in financial aid to help Americans pay for college or career school. The agency developed the FAFSA, and it processes some 20 million submissions, while disbursing, reconciling and accounting for all federal aid that is delivered to students through more than 6,000 colleges and career schools.

The William D. Ford Federal Direct Loan Program offers four types of loans, with the government as the lender. For undergraduates who can demonstrate financial need, a Direct Subsidized Loan may help cover costs. There is no interest while you are in school at least half time, during a six-month grace period after you finish the program or leave school, or during any authorized payment deferment period. Eligible undergraduate, graduate and professional students can take out a Direct Unsubsidized Loan, which is not based on financial need. The applicants pay the interest while they're in school or during grace periods or deferments.

For graduate or professional students, a Direct PLUS Loan may help pay for educational expenses not covered by other financial aid. Parents of dependent undergraduate students may use Direct PLUS Loans as well. Eligibility is not based on financial need, but a credit check is required. Interest, which is charged during all periods and will be added to the loan principal, increases the total cost of this loan. For students with other loans, a Direct Consolidation Loan combines all of their eligible federal student loans into a single loan, with a single loan servicer.

If you want a Direct PLUS Loan but you've had some credit issues, you will have to meet additional requirements if your credit history is deemed adverse: that is, if you have a total balance of more than $2,085 that is 90 or more days delinquent as of the credit report date, or has been placed in collection or charged off during the preceding two years. The same is true if you have had a default determination, repossession, bankruptcy discharge, foreclosure, wage garnishment, tax lien or a charge-off/write-off of federal student aid during the five years preceding the credit report. To get a Direct PLUS Loan with adverse credit, you may have to get credit counseling or find an endorser, who is essentially a cosigner.

B. Terms and conditions

How much can you borrow? For undergraduates, the maximum amount for Direct Subsidized Loans and Direct Unsubsidized Loans ranges from $5,500 to $12,500 per year, depending on the year in school (and dependency status). Graduate or professional students can borrow up to $20,500 per year in Direct Unsubsidized Loans. Direct PLUS Loans can also be used for the remainder of college costs not covered by other financial aid, as determined by your school.

To obtain the loan, you sign a master promissory note, which lists the terms and conditions, and your rights and responsibilities. The fixed interest rate is usually lower than that for a private loan, and no credit check or cosigner is required for most federal loans. Keep this document on file for information on deferments or forbearances, or when you begin to repay the loan. Repayment begins after you leave your program, or drop down to half time. Federal loans do offer flexible repayment plans and options to postpone your loan payments if you're having trouble making the payments.

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Private loans, another option, tend to be more expensive as the lenders — banks, credit unions and state-based or state-affiliated organizations — set the rules. While many require payments while you are in school, some allow deferrals. Their fixed or variable interest rates may be higher or lower than those for federal loans, and that interest may be tax-deductible. They are based on your creditworthiness, often require a cosigner and cannot be consolidated into a Direct Consolidation Loan. But you may be able to refinance. Borrowers should inquire about repayment options, the possibility of postponing or lowering the payments, and if there are penalties for prepayment. Few lenders offer student loan forgiveness, but some loans from state agencies may be forgiven under certain circumstances.

C. Loan forgiveness and repayment

Federal student loans, on the other hand, offer flexible payment plans and, for a number of reasons, may be forgiven, canceled or discharged. Patricia D. Hausknost, a certified financial planner in Long Beach, California, offers two examples: If a government or not-for-profit organization hires you, then you may be able to receive loan forgiveness under the Public Service Loan Forgiveness (PSLF) Program. “PSLF forgives the remaining balance on your Direct Loans after you have made 120 qualifying monthly payments under a qualifying repayment plan while working full-time for a qualifying employer."

In addition, if you teach full-time for five complete and consecutive academic years in a low-income elementary school, secondary school or educational service agency, you may be eligible for forgiveness of up to $17,500 on your Direct Loan. “And if your school closes while you're enrolled or soon after you withdraw, you may be eligible for discharge of your federal student loan,” she says.

When it is time to pay up, you can apply for an income-driven repayment (IDR) plan, with payments based on your income. If you qualify, you will be notified as to your eligibility and the payment amount. While this is an appealing option, there are four similar IDR plans with different qualifications, which can be confusing, warns Belle Osvath, a CFP and a Certified Student Loan Professional (CSLP) at VLP Financial Advisors in Vienna, Virginia. “Also, the percentage of your income you are required to pay changes depending on the repayment plan, and each plan differs in how the interest is, or is not, subsidized and/or capitalized,” Osvath says. How these plans calculate your income is also important. “Some require that your spouse's income be included if you file a joint tax return. But some do not, which may lower your payment significantly.”

Note to self: Once you sign that master promissory note, you've agreed to repay the loan according to the terms of the note — even if you drop out of school, you don't like the education you received, or you don't get the promotion, the new job, or make the career change of your dreams.

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