Q&A: Co-signing a grandchild’s student loan

Dear Liz: My granddaughter, who will graduate college in a year, has asked me to co-sign her third private loan, which will bring her total debt to $30,000. She needs three people to co-sign. Her parents and the other grandparents have agreed and she wants me to be the third party. I love my granddaughter and trust her intentions, but I really don’t like co-signing a loan for anyone. If I refuse, I’ll really be in the doghouse. Is there any way I could guarantee that I would only be responsible for this loan if the others don’t pay?

Answer: Co-signers are equally responsible for paying a debt. There isn’t a hierarchy. If your granddaughter fails to pay a loan, it will affect the credit reports and credit scores of anyone who co-signed that loan.

It would be unusual for any student loan to require three co-signers. What she may have meant is that her parents co-signed her first loan, her other grandparents co-signed the second and now she wants you to co-sign the third.

In any case, there’s no way to get the guarantee you want. If you’re not comfortable co-signing, don’t. Your family members should be the ones in the doghouse if they pressure you in any way to go along with this scheme.

Q&A: Refinancing an education loan

Dear Liz: You were asked a question about whether it would be wise to refinance a parent PLUS loan through a private lender and you said yes because the interest rates are so much lower. Doesn’t this ignore the benefit of the IRS tax credit? I figured out that my interest rate is effectively a couple of percentage points lower because I get a $2,500 tax credit every year.

Answer: As long as you’re refinancing with another education loan, the interest is still tax deductible. The deduction is “above the line” — meaning you don’t have to itemize to get it. The student loan interest deduction can reduce your taxable income by up to $2,500 if your modified adjusted gross income is less than $80,000 for singles and $160,000 for married couples filing jointly. The amount you can deduct is phased out at higher incomes and disappears after $90,000 for singles and $180,000 for marrieds.

If you’re not clear whether you’re refinancing into an education loan (rather than, say, a personal loan), you should ask your lender.

To clarify, it’s not always a good idea to refinance, even if you get a better rate. That’s because federal education loans have consumer protections that private lenders don’t offer. For example, you can pause your payments for up to three years if you lose your job or have another financial setback. Private lenders may offer hardship deferments, but typically those max out at 12 months.

Q&A: Pros and cons of refinancing college loans

Dear Liz: We took out parent PLUS loans to finance our two sons’ college tuition at private universities. We’ve received solicitations from a private lender offering to refinance. What are the pros and cons of doing so?

Answer: It rarely makes sense to replace federal student loans with private loans because the federal version comes with low rates, numerous repayment options, many consumer protections and the possibility of forgiveness. You lose all that when you refinance with a private loan.

Parent PLUS are a different story, however. Not only do they have higher rates (6.84% currently versus 4.29% for direct loans to undergraduates), but PLUS loans have fewer repayment options and no forgiveness.

If you have good credit and a solid employment history, you could dramatically lower your interest rate by refinancing with a private lender. Variable rates start at some lenders start under 2%, and fixed rates start under 4%. If you can’t pay the balance off within a few years, a fixed rate is probably your best option since rising interest rates could otherwise boost your payments.

A few private lenders even offer the option to have your child take over by refinancing your PLUS loan into his or her name.

You can shop for offers at Credible, a multi-lender online marketplace.

Q&A: Defaults on a co-signed student loan

Dear readers: A recent column about private student loans prompted financial aid expert Mark Kantrowitz to reach out with some additional advice for people who co-signed student loans for someone who has stopped paying. Although private student loans don’t have the same rehabilitation options as federal student loans, Kantrowitz encourages anyone in this situation to ask the lender, “What are my options?” and “Can you remove the default?”

“I’ve seen lenders not only remove the default from the co-signer’s credit history, but even reduce the interest rate if the co-signer agrees to make the payments by auto-debit,” said Kantrowitz, coauthor of the book “File the FAFSA.”

Someone who agrees to make payments may get a better deal than someone who pays off the loan in a lump sum, Kantrowitz said, because lenders want to be paid interest. But there would be nothing to stop a co-signer who makes payment arrangements to pay off the debt in full after a few months.

“This way he potentially can have the default entirely removed from his credit history, restoring him to his previous credit score,” Kantrowitz said. “It also leaves the account open, so that he can pressure the [borrower] into making payments.”

Q&A: Co-signing for a student loan backfires

Dear Liz: My wife and I both had excellent credit scores. Now mine are in the dump. I co-signed for a friend’s daughter’s school loan 10 years ago. I know now this was a bad mistake. I guaranteed $25,000. Now two things have happened: The daughter quit paying the loan and the friendship took a bad turn.

This is seriously hurting my credit. We have already been told when trying to refinance our mortgage that we’ll need to fix the school loan, which is showing more than 90 days behind. The outstanding balance is $20,000. I can pay the loan off. Making payments just adds interest to the problem. Are there any other options to repair my credit that don’t rely on the daughter’s ability to keep the loan current?

Answer: If you can pay the loan off, then do. You are legally responsible for this debt, and the longer it goes unpaid the worse the damage to your credit scores.

If this were a federal student loan, you would have the option of rehabilitation, which can erase some of the negative marks on your credit reports after you make a series of on-time payments. Because it’s a private loan — I know this because federal student loans don’t have co-signers — you probably don’t have a rehabilitation option (although it certainly doesn’t hurt to ask).

Once the loan is paid off, you can proceed with the refinancing but you probably will find that lenders want to base the loan on your battered scores, rather than your wife’s better ones. That means you might not qualify, or you might have to pay a much higher rate. If she can qualify for the refinance on her own, that’s one option. Otherwise, you might have to wait for your credit to heal before you refinance.

Q&A: Paying off student loan

Dear Liz: am going to pay off one of my daughter’s private student loans. One has a balance of $8,500 at 4% interest and the other is for $7,500 at 6%. Which one should I pay off?

Answer: You have a lucky daughter, either way.

In addition to balances and rates, the other variable you need to consider is whether the rates are fixed or adjustable. These days, many private student loans have fixed rates, but in the past most of this debt had variable rates. Variable rates mean higher costs and larger payments when interest rates rise.

If both loans have variable rates, or both are fixed, then paying off the highest rate debt first makes the most sense. If the lower rate loan is variable and the higher rate one is fixed, you’ll have to guess whether interest rates are likely to rise enough in the next few years to instead pay the larger balance first. Some people might want to pay off a variable debt just to eliminate the uncertainty, while others are willing to gamble that rates aren’t likely to jump two full percentage points before the loan is scheduled to be paid off.

Q&A: College savings strategy

Dear Liz: I will be 66 in May 2016. My wife is 68 and retired. She began receiving Social Security when she turned 66. I am still working, making a high six-figure income, and will continue to do so until I reach 70, when my Social Security benefit reaches its maximum. I plan to use my Social Security earnings to save for my grandchildren’s college educations (unless an emergency occurs and we need the income). I want to maximize the amount that I can give them. What is the best strategy, taking into consideration the recent change in Social Security rules relating to “claim now, claim more later”?

Answer: You just missed the April 29 cutoff for being able to “file and suspend.” Before the rules changed, you could have filed your application at full retirement age (66) and immediately suspended it. That would allow your benefit to continue growing while giving you the option to change your mind and get a lump-sum payout dating back to your application date.

Since Congress did away with file-and-suspend for people who turn 66 after April 30, that option is off the table for you. There are other ways to maximize your household benefit, said economist Laurence Kotlikoff, author of “Get What’s Yours: The Secrets to Maxing Out Your Social Security.” They include:

•Your wife suspends her benefit and lets it grow for another two years, then restarts getting checks when she turns 70.

•At 66, you file for a spousal benefit. People who are 62 or older by the end of this year retain the ability to file a “restricted application” for spousal benefits only once they turn 66. That option is not available to younger people, who will be given the larger of their spousal benefits or their own benefits when they apply.

•At 70, you switch to your own, maxed-out benefit. Again, the ability to switch from spousal to one’s own benefit is going away, but you still have the option to do this.

Consider saving in a 529 college savings plan, which offers tax advantages while allowing you to retain control of the money. You can even withdraw the money for your own use if necessary, although you would pay income taxes and a 10% federal penalty on any earnings.

You should know, however, that college-savings plans owned by grandparents can mess with financial aid. Plans owned by grandparents aren’t factored into initial financial aid calculations, but any disbursements are counted as income that can negatively affect future awards. One workaround is to wait until Jan. 1 of the child’s junior year, when financial aid forms will no longer be a consideration, and pay for all qualified education expenses from that point on.

Obviously, you won’t have to worry about this if your grandchildren wouldn’t qualify for financial aid anyway. If your children also make six-figure incomes, that’s likely to be the case.

Q&A: Student loans and mortgages

Dear Liz: I recently completed a master’s degree in counseling and am now paying student loans. I am punctual and consistent in my payments. How does having a $30,000 outstanding student loan look to home lenders? We recently sold our home and moved. We are planning to buy another home and have a large down payment. Does this student loan affect my home purchase potential? My husband and I are retired, and we pay our bills on time.

Answer: Student loans can have a positive effect on your credit scores if they’re paid on time. On the other hand, your payments are factored into the equation of how much mortgage you can afford and will reduce the amount you can borrow.

You should be rethinking the notion of borrowing more in any case. It’s not clear why you spent so much on a degree if you’re not using it. Perhaps a health setback made working impossible or an inheritance made it unnecessary. Generally, though, you should borrow for an education only if you expect it to increase your earning power enough to easily replay the loan. If you’re pursuing an education just for the pleasure of it or for a feeling of accomplishment, you should pay for it out of pocket or with savings.

A mortgage in retirement is tricky as well. Although some wealthy people keep their mortgages so they can invest the money elsewhere, most people are better off without loans once they stop working. Having to pay a mortgage often means having to take more out of your retirement funds and increasing the odds of running short of money. Also, remember that your income will drop when one of you dies because one Social Security check goes away. That could make it harder to pay the bills.

Consider meeting with a fee-only financial planner who can assess your financial situation and offer advice about the best course. It could be that you can well afford student loans and a mortgage. Or you could be headed for disaster. It’s better to find out while there may still be time to put that degree to work to boost your income or take steps to conserve your funds.

Q&A: Best way to pay for college

Dear Liz: We have two children in college, both entering their junior years. We have two more in high school. The two currently in college need additional financial assistance, as they’ve tapped out their federal student loans.

We are middle class, grossing about $125,000 a year, so we don’t qualify for much financial aid. We’re considering a cash-out refinancing of our home, but we feel as though we can do it only once, since each time we refinance it will cost us some fees, plus interest rates are likely to start edging up soon.

However, if we take out a big chunk of cash that could last us for the next two years for the first two children, and possibly some for the other two, we’re concerned that having that much cash sitting in the bank will reduce the amount of financial aid we receive, which would be counterproductive.

Is there a way to earmark the extra cash clearly for education expenses so that it doesn’t count negatively on our Free Application for Federal Student Aid (FAFSA)? Or do we just need to take this year’s cash out now, and refinance again each year (which seems crazy)?

As an aside, now that we have a little experience with this college thing, we will guide the two younger ones to community college or living at home while attending a less expensive public college, or something along those lines.

The first two just sort of went — without a lot of financial forethought.

Answer: The chunk of cash from such a refinance would be counted as a parental asset, provided the savings account is in your names and not those of your child.

So a maximum of 5.64% of the total would be included in any financial aid calculations. That’s not a big bite, but if you’re not getting much financial aid it could offset or erase the small amount you’re getting.

The bigger danger is that you’re taking on debt for something that won’t increase your own wealth or earning power. If you should suffer a severe-enough financial setback, such as a layoff, you could wind up losing your home.

In general, parents shouldn’t borrow more for their children’s college educations than they can afford to pay back before retirement — or within 10 years, whichever is less.

This rule of thumb assumes that you’re already saving adequately for retirement and will continue to do so while paying back the debt. If that’s not the case, you shouldn’t borrow at all.

If you’re going to borrow and can pay the money back quickly, a home equity line of credit may be a better option than a refinance. Interest rates on lines of credit aren’t fixed, but the costs are significantly less and you can withdraw money as needed.

Yet another option: parent PLUS loans, which currently offer a fixed rate of 6.84%. Approach these loans cautiously. It’s easy to borrow too much, since the program doesn’t consider your ability to repay. And like federal student loans, this debt typically can’t be erased in Bankruptcy Court.

Q&A: Paying off student loans vs saving for retirement

Dear Liz: I’m engaged to be married and need your advice on getting started in the world of shared finances.

My fiance is 43, I’m 31. He’s debt free, with a savings account but no retirement fund. I have $34,000 in student loans (consolidated at 4.25%) and it weighs heavily on my mind as I’m desperate to become debt free. I’m debt free otherwise with $10,000 in savings.

We both make good money but my income as a freelancer is sporadic, while his is steady with periodic bursts of additional income.

We want to be debt free as a couple, save up a solid emergency fund and start making up for lost time on retirement savings, all while being aware that a family and a house might not be far away.

He’s very supportive and wants to pay off my student loans. Should I let him and pay “us” back to the emergency fund or maybe a house down-payment fund? What’s our best course of action to start on a solid financial footing?

Answer: You’re already behind on retirement savings, which should have started with your first job. Your fiance is even farther behind.

Don’t let your zeal to repay your debt blind you to the very real risk that you might not be able to save enough for a comfortable retirement if you don’t get started now.

If your education debt consists of federal student loans, then your low rate is fixed. The interest probably is tax deductible, which means the effective rate you’re paying is just a little over the inflation rate. It isn’t quite free money, but it’s pretty cheap.

You don’t need to be in a rush to pay it off, particularly with all your other financial priorities looming.

Instead, get going on some retirement accounts. Your fiance should take advantage of his workplace plan, if he has access to one.

Most employer-sponsored workplace plans have company matches, which really is free money you shouldn’t leave on the table. An individual retirement account or Roth IRA can supplement the plan or be a substitute if he doesn’t have access to a workplace plan.

As a freelancer, you have numerous options for setting aside money for retirement, including Simplified Employee Pensions (SEP), Savings Incentive Match for Employees (SIMPLE) and solo 401(k)s that would allow you to contribute more than the standard $5,500 annual limit for an IRA.

Ideally, you would be saving around 15% of your income and your fiance 20% or more.

If you can’t hit those targets just yet, start saving what you can and increase your contributions regularly. Work your other goals around the primary goal of being able to afford a decent retirement.