Ask Liz Weston

Dear Liz: My daughter is a sophomore at a very expensive college, and federal loans cover only $6,500 of her costs. She has taken out two private student loans with me as a cosigner, one at 6.5% interest and the second at 9.9%. I need $15,000 more for this semester’s tuition. I am an unemployed single mother but cannot get much financial aid. She is an above-average student but cannot find any awards or scholarships.

Answer: Your daughter may need to look for a less expensive education, since it appears neither of you can really afford the one she’s getting.

Unlike federal student loans, private student loans tend to be expensive, with variable rates and less flexible repayment options. Borrowers can easily find themselves taking on far more debt than they will be able to repay after graduation, yet this debt typically can’t be discharged in bankruptcy — it can follow your daughter for life.

A better option, if you must borrow, is for you to take out PLUS loans. These are federal loans for parents and graduate students that allow you to borrow the difference between your daughter’s college costs and any financial aid, including federal student loans, she gets. The rates are fixed at 8.5% or less.

PLUS loans do require a credit check. If you don’t pass — you’re 90 days or more overdue on a bill or you’ve had a bankruptcy in the last five years, for example — your daughter’s eligibility for student loans would be increased somewhat to help compensate.

But both of you should be thinking about alternatives. You really shouldn’t borrow money if you don’t have a way to pay it back. When you’re unemployed, taking on $15,000 a semester in debt is pretty foolish.

If her school won’t reconsider her aid package in light of your unemployment, she should be researching less expensive schools to which she could transfer her credits.

Dear Liz: I have twin boys and have been looking for a college fund to set up for them. Most bank saving accounts don’t pay much interest. The only thing I have found that is halfway decent is a certificate of deposit. My grandmother set up a trust for me, but I don’t know whether that’s a good idea these days. Do you have any ideas that would help?

Answer: You’re actually asking two questions. The first is what vehicle to use for college savings, and the second is how to get a decent return on your money.

Let’s take the latter question first. Bank savings accounts or certificates of deposit are fine if your kids are headed off to college in a year or two, but these low-risk investments won’t give you much growth on your money. In fact, you’ll almost certainly lose buying power over time when you consider inflation. If your money is in a taxable account, you’ll lose that much more.

Many parents opt to take more risk in order to accumulate more funds. If college is 10 years or more in the future, investing at least some of the money in stocks or stock funds makes sense.

The vehicle you use is also important. If you expect to get financial aid, you’d be better off avoiding custodial accounts such as Uniform Transfers to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts. These were popular accounts years ago when tax rates were higher, but they count heavily against you in financial aid formulas.

Many families find 529 college savings plans to be the best choice. These state-run accounts allow your contributions to grow tax-free for college and are treated favorably in financial aid calculations. These plans typically offer a choice of investment options, including age-weighted options that start out more heavily invested in stocks but that ratchet back exposure to risk as college draws closer. For more information, visit SavingForCollege.com.

Dear Liz: Are banks still lowering the amount of available credit? I’m concerned because we were hoping to use our home equity line of credit to pay for our children’s college educations, if need be.

Our current balance is less than 5% of the total available limit, but my credit reports show our credit line lender recently reviewed our credit history. I am concerned that our bank will lower our available credit as my son is about to start college. Are my concerns valid?

Answer: Perhaps. Lenders have been reducing home equity lines of credit as home values drop. If your mortgage balance and your line of credit total more than 60% of the current value of your home, you may be at risk of having your limit reduced right when you planned to use it.

If that’s the case and your son is heading off to school in the next year, it might be prudent to withdraw the money now and keep it in a savings account.

If college won’t start for several years, though, you might want to explore other options, since it’s generally not a good idea to borrow money so far in advance of when you’ll need it.

Fortunately, you have plenty of options when it comes to paying for college. Just make sure you fill out a Free Application for Federal Student Aid. Even if you don’t qualify for need-based aid, filling out the FAFSA will allow you to apply for federal student loans. Your son can get Stafford loans at a 6.8% fixed rate and you could get PLUS loans with a fixed rate ranging from 7.9% to 8.5%. Although the amount of student loans your son can get is generally limited to $31,000 for an undergraduate degree, PLUS loans allow you to borrow whatever you need to cover any costs not paid for by the student’s financial aid package.

Dear Liz: I would like to know how best to use a $100,000 inheritance. I am a stay-at-home mom, age 46. My husband, 42, earns $100,000 a year.

We owe $132,000 on our house and have no other debt. We pay off our one credit card in full monthly. He puts the maximum into his 401(k). We have two sons, ages 5 and 8.

Should we use the money to pay down our mortgage? I’m not interested in saving for college. We will be retiring about the time the kids are ready for college and we plan to have them take out student loans.

Answer: If you can save for college, you probably should.

College costs show few signs of moderating, so your older child might face a bill of $140,000 for an in-state public college or $200,000 or more for a private or selective public college. The cost for your younger child will be even higher. If they borrow the entire cost, they’re likely to remain financially disadvantaged for years. Students who overdose on loans often can’t save enough for retirement and delay starting families and buying homes because of their debt. Anything you save for them could reduce that terrible burden.

You also might want to rethink the idea of retiring when they start college. Even if your husband has been maxing out his retirement fund, it’s unlikely he’ll have saved enough by age 52 to last the rest of your lives, particularly if you have to start paying for health insurance on your own. (Medicare isn’t typically available until you’re 65.)

You didn’t mention savings. Most people should have an emergency fund equal to three months’ expenses, but families with just one earner typically should shoot for six or even nine months’ worth.

In any event, you almost certainly have better things to do with your money than pay down low-rate, potentially tax-deductible debt such as a mortgage.

A better approach might be to divide your inheritance into thirds, investing a third into an emergency fund, a third into your boys’ educations and a third into retirement funds.

A visit to a fee-only financial planner could help you sort through your options and clarify your goals.

Dear Liz: I have been accepted to my dream school. However, the school isn’t giving me much aid and I am expected to pay $50,000 a year, or a total of $200,000, if I get through college in four years. Although that is a huge amount of debt to carry, I think a cosmopolitan city would provide useful networks for me as a business major. What is your opinion on this?

Answer: As a business major, you’ll be doing plenty of cost-benefit analyses. Do one now, before you chain yourself to a lifetime of debt.

The general rule of thumb is not to borrow more for an education than you expect to make your first year out of school. A basic business degree is highly unlikely to land you a $200,000-a-year job.

What’s more likely is that you’ll need an MBA to vault into the high-paying leagues — a degree that will require further borrowing.

Understand that massive student-loan debt will have repercussions for the rest of your life. Since this debt can’t be erased in bankruptcy, you’ll be saddled with huge payments that could prevent you from buying a home and saving adequately for retirement.

What makes more sense is tweaking your dream a bit to get an education you can afford. And here’s the good news: Students accepted to Ivy League schools tend to do well in life regardless of the institution they actually wind up attending, according to research by economists Alan Krueger of Princeton University and Stacy Dale of the Mellon Foundation.

So choosing a less-expensive education doesn’t mean diminishing your prospects. Saying goodbye to your dream school will be sad, but far sadder is throwing away the rest of your financial life with too much debt.

Dear Liz: Our question is about student loans.

We have a total of $69,000 in education debt. We also have a home worth $400,000 and our mortgage balance is $266,000, plus a home equity loan with a balance of $14,500.

We make a good salary, have excellent credit, pay all our bills on time, and, if gas weren’t so darn high, we would have a decent amount of discretionary income.

 

Does a home equity loan make sense in this case?

Answer: Generally speaking, trading student loan debt for home debt isn’t a great idea.

Student lenders typically are much more flexible than mortgage lenders, with a wider variety of repayment options. You also can get a deferment or forbearance if you lose your job or otherwise encounter a financial hardship. This respite from payments can last as long as three years on many student loans.

Compare that with what would happen if you couldn’t make your mortgage payments. Within a year, and usually much less, your home lender would start foreclosure proceedings.

In addition, most student loan debt can be consolidated. This would allow you to lock in your current interest rate and perhaps lengthen the repayment term to lower your monthly payments.

A longer loan means you would pay more interest over time, but it could help ease the monthly crunch you’re feeling.

All that said, not being able to deduct the interest on your student loans is a significant disadvantage.

If you’re confident you’ll be able to make the payments, then you might consider paying off at least some of your student loan debt with home equity borrowing.

You should, however, limit your total borrowing — all your home equity loans plus your primary mortgage — to no more than 80% of the value of your house.

You want to keep at least a 20% equity cushion in your home whenever possible, as a last-resort emergency fund and also to protect yourself in case of declining home values. (You don’t want to be faced with having to sell your home and owing more than it’s worth.)

Given the loans you already have, you should be able to pay off $39,500 of your student loans with home equity debt. Then you could consolidate the remaining $29,500.

Q: We are facing a challenge in regard to financing our son’s education. We are being asked to contribute $30,000 a year for a private college education. Is this really a wise move? We have a daughter who will be in college in two years. Help!A: A good education is virtually essential to success in today’s competitive, global economy. That said, there are plenty of ways to get a good education, and bankrupting yourselves on a too expensive college shouldn’t be one of them.

 

If you can’t manage this bill without sacrificing your own retirement plans or your daughter’s education, then you need to think about some options.

If your son has his heart set on this college, then he should be willing to take on at least part of the cost by incurring student loans. (He should be careful, though, to make sure that his total student loan debt doesn’t exceed the salary he expects to make in his first year out of school.)

Another option, obviously, is for him to attend a less expensive school for at least a couple of years, if not the duration of his education.

The fact that you’re asking this question just months before your son starts college indicates that you haven’t done enough thinking and planning, but it’s not too late.

Head to the bookstore or library and grab a copy of a college financing guide and explore your options. You might also use FinAid.org’s expected family contribution calculator, available at http://www.finaid.org , to estimate how much you’ll have to kick in once your daughter starts school.

Good luck.

Dear Liz: I’m starting to think that I made a huge mistake when it came to my choice for an education, but I was accepted to my “dream school” and I couldn’t pass up the opportunity to attend. As of now, I have a degree from a top-rated university as well as a master’s degree and about $115,000 of debt. I’m only making about $27,000 a year and must remain in my job for the next two years. I am paying over one-third of my monthly income towards these loans and don’t know how I am going to survive with this amount of debt. I really hope I don’t come to regret my schooling decision and all of the hard work I put into it. Right now, though, I have nothing to show for my effort other than a piece of paper. What’s your advice?

Answer: Unless your income will shoot dramatically higher in the next few years, the amount of debt you incurred was insane.

Generally, you shouldn’t borrow more for school than you expect to make in your first year out of college. If you have to take on much more debt than that, then you really can’t afford the education you’re buying, “dream school” or not.

What you’ve done is saddled yourself with debt that will inhibit or even prevent you from pursuing other important goals, like buying a house or saving for retirement. You’ve dramatically increased the chances that you’ll fall further into debt just trying to live day-to-day, since so much of your income is going toward these loans.

This is not a burden that you can escape, either. Unlike most other unsecured debt, student loans can’t be erased in bankruptcy court. Lenders are allowed to pursue this debt virtually to the grave: the U.S. Supreme Court recently ruled that student lenders could garnishee the disability check of a senior citizen for unpaid loans.

You might be able to put a small dent in the amount you owe with a loan forgiveness program, which typically pays part of your debt in exchange for activities like teaching in an inner-city school or enlisting in the armed forces. You can explore the details at a financial aid information site like FinAid.org.

But the real solution to your problem is pretty basic: you’re going to have to find a way to earn a lot more money. You didn’t explain why you have to keep your current job for two years, but if you really can’t move on then you should spend the time readying yourself for the highest-paid profession for which your degrees qualify you. This might not be your “dream” job, but it could save you from the nightmare of excessive debt.

Dear Liz: My teenage daughter has a modest amount in a Roth IRA that has only a very small gain. I am thinking about using the principal on her private high school tuition so that the account is not considered when she applies for college tuition aid. Is this shortsighted?

Another factor is that I have inherited part of the estate of a relative. Although the transfer isn’t finalized, I probably will get the money during the same year that will be used to determine the financial aid for her first year in college.

Would she be better off if I left the Roth alone and used the inheritance? Or should I reduce the funds in her account?

Answer: Leave that Roth alone!

Retirement funds aren’t included in federal financial aid calculations. And it’s an awful idea to use retirement funds for educational expenses in any case.

Left alone, even a modest sum in a Roth can grow substantially, particularly because it will be 50 years or so before she reaches retirement. In that time, a $5,000 balance could grow to nearly $235,000, assuming she averages 8% annual returns.

Your inheritance will affect your daughter’s financial aid package, but perhaps not by as much as you think. The federal aid formula generally requires you to contribute less than 6% of your “discretionary” assets toward your children’s education.

Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.

I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuity—even a low-cost annuity—beat a reasonably tax-efficient mutual fund over any time period.

As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!

Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.

Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.

However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.

This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.