A primer on student loans

Borrowing money is probably the least desirable way to finance a college education.

The best way would be to use assets that parents had saved while their children were growing up. Using current income to defray at least some college expenses as they arise is another good way. Even better would be to reap a huge windfall -- a winning lottery ticket or, more realistically, grants and scholarships that never have to be repaid.

But if these money sources aren't available, then it's smarter to take out student loans than it is to forgo a college education. Consumers routinely borrow money to finance things they otherwise can't immediately afford to own, such as a car or home furnishings. But unlike these things, a college education is a genuine investment that almost always results in higher earnings. The often-cited earnings advantage for a college grad vs. a high-school grad is a million bucks over a lifetime.

The decision about who should incur the debt -- the student, the parents or a combination -- is one that each family must make on its own. But if parents have to choose between funding their children's education and investing in their own retirement, then they'd better look out for themselves. Loan officers in their right minds would not approve a loan application from a 65-year-old couple looking for retirement funding. But financial institutions are eager to do business with young, penniless students who need funds for college.

Federal loans vs. private loans
Why would anyone take chances on students with little or no credit history? Many lenders participate in federal programs in which loans are guaranteed by the government. It's typically a good deal for students, too, since they're afforded money at a cheaper rate than they would get from alternative sources.

The catch: Before they can apply for these loans, students must fill out the Free Application for Federal Student Aid, or FAFSA, and wait for the results. Yes, it's a bureaucratic process, but well worth the trouble.

Private lenders sometimes try to entice students with the promise of ease and convenience. A typical ad for a loan might say this: "No FAFSA financial aid qualification process! Less paperwork!" A truer version of this ad would say: "Pay higher interest rates! Make bigger payments through the life of the loan!" Bottom line: If you fall for the easy, convenient route, you could end up paying much more in the long run.

Rates still a good deal
For the 2004-2005 school year, student loan rates had reached historical lows, but on July 1, rates increased by nearly 2 percentage points.

Even with the recent rate hike, federal loans are still a relative bargain. Imagine you just finished school and have $20,000 in Stafford-loan debt. At the current rate of 5.3 percent, your payment would be $215, assuming a 10-year repayment period. At last year's rate of 3.37 percent, using the same assumptions, the payment would be about $197, a difference of only $18 per month. A rate of 9 percent from a private lender makes the payment go up to $253 -- that adds up to some serious pocket change.

Under the federal program, certain student loan rates are variable, changing every July 1. The way the rules work now, students get a one-time chance to lock in a fixed rate if they elect to consolidate some or all of their loans at one time, though these rules may change.