College years spell debt

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When it comes to college, it’s the year of debt.

Prices continue to soar, with tuition now running an average $23,217 a year at four-year private universities and $6,185 at four-year public institutions, according to recently released findings from the College Board.

Those figures no longer trigger sticker shock. Rather, they’re causing full-blown paralysis. More than half (54 percent) of families planning to send children to college have amassed a meager $5,000 or less to pay the tab, says the nonprofit group, College Savings Foundation, or CSF.

Many are simply resigned to years of debt. Four out of 10 families expect to spend at least a decade paying off college-related debt, and 82 percent think it will take five years.

That seems to be a realistic projection. The typical college grad now leaves school with $19,646 in school debts, according to The Project on Student Debt.

College debt was a much-debated issue in Washington, D.C., over the past year as lawmakers discussed what could be done about the high price of college. Recently passed laws, meant to protect families who borrow for college, start to take effect as early as 2008. Other legal overhauls are expected throughout the year, too.

Rates on government loans will drop in 2008, making it cheaper to borrow from Uncle Sam. Federal grants are due for immediate and long-term increases. Also, the private sector has been stepping in, with a few colleges, like Williams, Wesleyan and Bowdoin, announcing that they’re eliminating loans as part of their financial aid packages.

The bottom line is that college costs aren’t likely to drop in the near future, but there is some improvement. Smart students and their families will adopt up-to-date strategies to capitalize on new benefits so they can save as much as possible, borrow wisely and protect their bottom line as much as possible. Here’s how:

Apply for financial aid ASAP

There’s more reason to apply for financial aid in 2008 than ever: Uncle Sam has loosened the purse strings on federal grants, and interest rates on government loans are going down.

That said, the first step is applying for aid by filling out the Free Application for Federal Student Aid, or FAFSA, which you can obtain from schools’ financial aid offices or from the Department of Education’s Web site.

You can submit your FAFSA any time after the New Year to apply for aid for the 2008-2009 academic year, but you don’t want to drag your feet. You’ll want to get it in ASAP, and certainly as soon as you complete your 2007 taxes.

“Most colleges do not award aid on a first-come, first-serve basis, but students who miss deadlines do miss out,” says Sandy Baum, senior policy analyst at the College Board.

Once the FAFSA is complete, you may qualify for free grant money. This year, there’s good news for those who get it. The federal Pell Grant for the nation’s neediest students will rise to $4,800, up from $4,310. What’s more, the grant also will grow steadily each year until 2012, when it will be worth $5,400. The hikes reverse a trend in which the Pell had been getting smaller in relation to tuition increases.

“We’ll finally see some catch up for the lack of aid increase in the past,” says Robert Shireman, executive director of The Project on Student Debt.

Those who qualify for the Pell may also be due for two new grants that were unveiled in the past year: the Academic Competitiveness Grant and the SMART Grant.

The Competitiveness Grant is worth up to $750 for the first-year undergrads and up to $1,300 for second-year students. The SMART, or Science and Mathematics Access to Retain Talent, is worth up to $4,000 and is open to Pell Grant recipients in their third or fourth year of undergraduate studies who major in math, science, engineering and the like.

Snag cheaper-than-ever government loans

That said, the bulk of financial aid comes in the form of loans, which have to be repaid, so the big question for students going to college isn’t whether or not to borrow, but how to borrow wisely.

The best way to borrow wisely is to borrow from the government.

Federal loans aren’t only cheaper than private deals, they offer greater protections in avoiding huge debts. That’s especially true this year, because lawmakers have passed reforms to keep government loans affordable.

Remember that federal deals like the so-called Stafford loans, designed for undergrads, or PLUS loans, created for families and grad students, come with fixed interest rates, so you know they won’t skyrocket in the future. That’s not always the case with private loans, says Peter Mazareas, treasurer for the College Savings Foundation.

“The federal loans have much better rates and they’re fixed,” Mazareas says. “So families should lock in now during this low-interest environment.”

Government loans are getting cheaper. Consider interest rates on Stafford loans, which are reset annually and are taken out by students. Stafford loan interest rates are currently at 6.8 percent. They’re due to drop to 6 percent July 1, 2008, and in coming years, Staffords will get even cheaper, until interest hits a low of 3.4 percent in 2011. In 2012, they’ll revert back to 6.8 percent unless Congress intervenes again.

PLUS loans, available to parents as well as to graduate students, also have current fixed rates of either 7.9 percent or 8.5 percent.

Get added protections for government loan debt

There’s additional good news for those who borrow from Uncle Sam. The College Cost Reduction and Access Act, which was signed into law in September, has a slew of provisions to protect borrowers once they begin repaying their government loans.

Most notably, the law has put a cap on debt limits, so borrowers don’t have to devote more than 15 percent of their income to repay Stafford and Perkins loans, and PLUS loans for graduate students. This new protection applies regardless of when these loans were taken. Caps are set on a sliding scale based on an individual’s income. In practice, most borrowers will “not have to spend more than 10 percent of their income” on loan repayments, says Shireman.

What’s more, the new law includes a loan forgiveness feature that guarantees borrowers won’t be stuck with loans for the rest of their lives. Specifically, unpaid loan balances are forgiven after 10 years for those who teach, serve in the military, work as librarians, nurses or in other public-sector, nonprofit jobs for at least 10 years. For borrowers in other professions, outstanding balances on loans are forgiven after 25 years.

“It makes sure there’s an endpoint so people aren’t in a situation where debt continues into Social Security years,” says Shireman.

Be wary of private loans

It’s worth noting that the repayment protections don’t apply to private loans. That’s not to say they didn’t receive congressional attention, however. Private loans now make up nearly a quarter (24 percent) of all education loans, up from just 6 percent a decade ago, according to the College Board.

Critics maintain that the boom has come at great cost to borrowers, who don’t receive adequate information about how their loans are structured. Others have maintained that private lenders make deals with universities to get on colleges’ “preferred lender” lists.

A proposed National Student Loan Sunshine Act, which hasn’t yet been passed by the Senate but is expected to pass and become law in early 2008, would require private lenders to more clearly divulge their repayment terms. This would include rules that force banks and the like to state how high the interest rates on their variable loans could grow over the life of someone’s loan.

The Sunshine Act also seeks to ban so-called “co-branding” of private loans that boast the name of a university but are really offered by banks. Critics say these loans, which are made available to students through their financial aid offices, give the appearance of being vetted by schools, and possibly being the cheapest available, though that may not be the case.

So tread lightly before signing the dotted line on private loans. Ask tough questions, like finding out if your lender puts caps on interest rates. (For more tips, see Bankrate’s guide to private loans.)

Bear in mind that experts recommend families use a PLUS loan to obtain necessary funds for college if the Stafford isn’t adequate. This will ensure they get a fixed-rate deal.

Start saving now

It bears repeating that no matter what changes are made to regulate lending practices or to boost financial aid, the burden of college costs falls squarely on students. If your kids are years away from college consider yourself lucky, then open a college fund pronto.

“The single biggest reason families aren’t saving is because there’s this misperception that they’ll get financial aid,” says Mazareas. “Or else parents feel inertia. They wonder, ‘How do I get started?'”

The answer to that question is a simple one. You take baby steps.

After all, 2008 probably won’t be the year you reap in mega lottery winnings. But it can be the year you make a commitment to save regularly. If you can have automatic deductions taken from your paycheck or savings account on a monthly or weekly basis, you’ll do more for funding your future than waiting for the day when you can afford to set bulk sums aside.

Let new 529 features work harder for you

You don’t need to set aside a mint to get started if you save smart. You can open a 529 plan for as little as $25 in some states, like Illinois and Iowa. (Plans are sponsored by states but you don’t have to be a resident to open one.)

Not only are 529s affordable, they enable your savings to grow tax-free over time. Earnings are taken out tax-free if they’re used for higher education costs, such as tuition, room and books.

These benefits have been drawing investors to 529s for years, and assets in plans now total $104.9 billion. Nevertheless, only one out of three families has opened a 529, and states that sponsor 529s, which are run by fund companies like Vanguard, T Rowe Price, TIAA-Cref and Fidelity, are working hard to attract individuals with a slew of improvements.

Most notably, plans are getting cheaper. In general, direct-sold 529 plans, which you open by contacting the plan management yourself, are less expensive than broker-sold 529s, which are obtained via middlemen.

But recently the industry has seen lower fees overall, says Marta Norton, a mutual fund analyst at Morningstar. In the past year, for example, fees have been lowered in 529s offered in Alaska, Illinois and West Virginia, among other states.

“The competition is more fierce, and there’s a lot of fine-tuning being done to them,” says Norton. “There’s a lot more industry awareness of what other 529 plans are doing and consumers are going out and comparing what’s out there.”

It’s also getting easier to claim a tax break with a 529. Currently, 34 states allow residents who participate in their sponsored plan to deduct all or some of their 529 contributions. That said, you don’t have to fund a 529 sponsored by your home state.

But some states like Kansas, Illinois, Pennsylvania and Maine are letting residents claim a tax break for saving in a 529 regardless of where they open their plan. In July, Arizona became the latest state to extend parity when it passed a law allowing residents to deduct up to $750 in contributions to any 529 from their state taxes.

You can start finding the best plan for you by logging onto various Web sites, which also have improved lately. Morningstar recently unveiled a new 529 Plan Finder that lets individuals compare the performance of various 529s as well as fees, tax treatment and the like. Bankrate also has a map that compares 529 plans in each state.

Another option is, which rates plans and also lets you compare such things as a plan’s various fees, minimum contribution limits to open and fund the plans, the kinds of investment choices offered and tax perks that may be available to participants.

Don’t forget Wall Street

Salting money away is a good first step, but if it’s not invested for growth you’ll be doing yourself (and the future student) a disservice. Unfortunately, too many are doing just that.

The College Savings Foundation study found that more parents — 31 percent — have put their college savings in cash than any other investment choices such as stocks, bonds or mutual funds available. Trouble is, the returns offered by money market funds or other “cash” equivalents won’t give you the kind of returns necessary to amass a significant college nest egg. Bonds, for example, have gained 5.44 percent annually, while Treasury bills grow about 3.79 percent, according to Ibbotson Associates, a subsidary of Morningstar.

So don’t play it too safe, especially if your future grad is still in diapers. You’ll need to buy stocks, which historically have grown 10.65 percent a year.

How do you strike the right balance between high return and risk? You can eliminate some of the guesswork and stress by opting for a 529 plan that offers age-based investment portfolios. Assets in these funds, which include stocks, bonds, cash or a mixture of all three, are automatically rebalanced over time, becoming more conservatively invested as students near college.

Don’t assume all age-based 529 funds are the same. Some may be more or less aggressive depending on who’s offering them, says Norton.

“Investors have to look at the underlying asset scheme to see if they’re getting something too conservative or too aggressive,” Norton says. “But if the asset allocation is something they’re comfortable with, then the age-based funds make a lot of sense. It takes the pressure off of individual investors to determine the precise moment to move to fixed income.”