Navigating the Student Loan Maze

Question of the week:My high school age son is starting to think about college, and I'm starting to get nervous about paying for it. Can you provide some guidance on student loans? --Andrew G.

Dear Andrew,

Given the high cost of college these days, your worry is quite understandable. According to Nellie Mae, one of the leading national providers of college loans, the average undergraduate student loan debt today is $18,900.

But the news really may not be all bad. When we asked members of the Armchair Millionaire community recently about how they are handling their student loans, many told us how they are making lemonade from lemons. This story was typical:

"My parents helped me as much as they could to pay for college, but I still have a lot of loans. Recently, I consolidated my loans to lock in a fixed rate of less than 4 percent interest and a slightly longer term. I intend to pay off the minimum through an automatic debit system (which also lowers my rate) and invest extra money I would put toward the loans in a Roth IRA." --Jason

Before you (and your son) plunge into debt for college, you should have a very clear understanding of your student loan options. My guide provides the basics on the most common choices.

The Armchair Millionaire Guide to College Loans

• Stafford student loans. These are federal loans with low interest rates, extended and flexible repayment terms, and that do not require collateral. They also offer options for deferment. The loans may be made either from a private source, like your bank, credit union, or savings and loan (in this case, the loan is guaranteed by the government), or else directly from the federal government. The interest rate is variable, but capped at 8.25 percent. For the 2002-2003 school year, the interest rate is 4.06 percent. There are two different kinds of Stafford loans:
  • Subsidized. The government pays the interest on the loan while the student is in school, and repayment does not start until six months after graduation or leaving school. These loans are need-based.
  • Unsubsidized. The student is responsible for the interest during school, although he or she can defer the payments until after college. These loans are not need-based, so anyone, regardless of income, is eligible.
  Undergrads who are dependents can borrow up to $2,625 their freshman year, $3,500 their sophomore year, and $5,500 for each of the final two years. Some students end up with a combination of both subsidized and unsubsidized loans to make up the maximum.

• Parent Loans for Undergraduate Students (PLUS). As you can guess from the name, these are for mom and dad. Like the Stafford, the PLUS is a federal loan, and is available either from private lenders or directly from the federal government.

  The PLUS has a much higher limit than the Stafford--up to the entire cost of the child's education, minus other financial aid. Interest rates are variable, but capped at 9 percent, with repayment starting 60 days from the time the loan is given. For the current school year, the interest rate on PLUS loans is 4.86 percent. Unlike the Stafford, PLUS loans are in the name of the parents, and are their responsibility.

• Private loans. If you need still more borrowing choices, you can turn to a private loan from a bank. Your bank may offer a lower interest rate or other favorable options when the money will be used for education than for regular consumer loans. Parents are generally the borrowers, although the student can apply, too (assuming that he or she is credit worthy.) The terms for these loans will vary considerably from one lender to the next, so compare several to find the best interest rate and most convenient repayment arrangements.

THE BOTTOM LINE: Sending a child to college without incurring debt is simply not an option for many parents. But by choosing your loans wisely, you can minimize the pain.

Putting Your Home on the Line

Question of the week:I'd like to take out a home equity line of credit, but my wife hates the idea of going into more debt. What's your opinion about it?
--Tony C.

Dear Tony,

Plenty of people these days have the same idea. In fact, according to the Federal Reserve, homeowners' equity as a percentage of overall residential real estate value is now at an all-time low (about 56 percent), mostly due to the recent rush of mortgage refinancing and home equity loans and lines of credit.

But just because so many people are doing it doesn't automatically make it a good idea. When we asked Armchair Millionaire community members for their opinions, we heard arguments both for and against. Here are two examples:

No way. "A home is the best vehicle most Americans have for savings. By continuously extracting the equity in your home, you only perpetuate the attitude that cash is better than net worth." --Rick I.

Absolutely. "I always apply for one when I purchase a house as it can be done at the same time as the loan papers. I've used it for home improvements/repairs and bought my last car on it. When I sold the house, the car was also paid for, using cheap money!" --Jean

Home equity loans and lines of credit are popular for several very good reasons:

• They're usually tax deductible. Depending on your situation, the interest you pay on your line of credit may be deductible. (See your tax advisor).
• They have low interest rates. Because they are secured by your home, their interest rates are lower than for most other types of credit.
• They're fast and easy to get. You can typically obtain your line of credit in just a couple of weeks, and with low (or no) closing costs
• You can use them however you like. There are no restrictions on how you use the money. Make home improvements, vacation in the Caribbean, buy a boat--the choice is yours.

However, even though home equity loans and lines of credit can be used any way you choose, I still don't believe that they are right for every purpose. My guideline provides recommendations for when it's a good idea to tap your home's equity, and when it's not.

The Armchair Millionaire Guide to Using Your Home Equity

• Home improvements. I think this is the best possible use of home equity, because it puts the money right back into your house. Word of warning: Not all home improvements will result in an increase in your home's value. A kitchen or bath makeover probably will; new landscaping probably won't.

• Higher education. Home equity can be a great source of tuition funds if your child doesn't qualify for financial aid. Word of warning: If you're getting close to retirement and repaying the loan will severely impact retirement income, it's advisable to steer your child towards student loans, instead. The rates for student loans are often lower then those of home equity loans and lines of credit, and the interest may be tax deductible.

• To pay off debt with a higher interest rate. Paying down high-interest credit card debt with home equity can save you hundreds or even thousands in interest, as well as provide a nice tax break. Word of warning: Undertake this only if you have a concrete plan for changing your spending habits to stop incurring additional credit card debt. Otherwise, you'll just end up with more credit card debt and depleted home equity.

• Emergencies. A home equity line of credit is one alternative to an emergency fund of cold cash. (Remember that the time to arrange your line of credit is before you're faced with an emergency. If you've just lost your job, you may not get approved.) Word of warning: Having a line of credit is no excuse for not doing all you can to minimize the cost of emergencies--this means having the right kind of insurance, and enough of it.

• To pay for ordinary living expenses. This is an absolute no-no. If you feel you must use your home's equity to pay for day-to-day expenses, you need to re-evaluate your entire financial situation. Look at where you can cut spending or increase income, but don't risk losing your house in order to live beyond your means.

THE BOTTOM LINE: Your home is probably the biggest investment you have. Think very carefully before acting to deplete the value of that investment.

How Big a Nest Egg?

Question of the week:I've been saving for retirement for some time now, but I really have no idea if it's enough. How can I find out the total amount that I'll need to retire comfortably? --Joplin Mom

Dear Joplin,

You're to be congratulated for trying to arrive at the amount you'll need for retirement. You're definitely in the minority in taking this important first step to securing your future. According to a 2002 survey by the American Savings Education Council, only about one-third of all workers say they have tried to figure the amount they will need for their retirement years.

We recently asked members of the Armchair Millionaire community about how they are calculating this amount. These comments highlight just two of the many variables that need to be taken into account:

Is the house paid for? "We figure that by retirement, our home will be paid off, and we won't be saving for retirement, so we will only need about one-half the income we get now." --Meg H.

Will you have a pension? "It can vary by a tremendous amount depending on if you/spouse will have a pension. If you don't, the amount you will need could exceed $2 million." --Dave H.

There is no fast, easy way to know exactly how much you'll need to retire in style. You need to consider two types of variables: those you can predict with accuracy (such as what you can save now and the annual income you'd like to have during retirement), and those you can only take an educated guess at (like the rate of inflation, the return on your investments both before and during retirement, and how long you'll live).

There are a number of different retirement planning calculators available on the Web for free, and they are also included as part of many personal finance software packages. To varying degrees, these calculators take the variables into account and provide you with an amount that you will need and what you need to save now to reach that goal. I strongly encourage you to run the numbers with several of these calculators.

Here are some sites with retirement planning calculators:

• Money.com
• Quicken.com
• FinancialEngines.com

It's very likely that the amount you arrive at will surprise you. Depending on how much income you'd like to have during retirement, the total amount you'll need could easily exceed a million dollars. But don't let this discourage you. By taking a few common sense steps, you'll put your goal well within reach. My checklist will get you started.

The Armchair Millionaire Checklist for Growing Your Nest Egg

• Start small but think big. Compounding returns on your savings will make a little grow to a lot. For example, by saving just $300 a month, with a nine percent average annual return, you'll end up with a bit over $500,000 in 30 years.

• Minimize your taxes. Every buck you don't have to pay in taxes is another buck for your nest egg. Maximize every tax-advantaged account available to you, including an IRA and 401(k).

• Invest smart. This means buying and holding for the long term, using intelligent asset allocation and minimizing your costs. Index funds are the perfect tools for doing all of this.

• Dollar cost average. Worried about investing at the wrong time? Then invest the same amount every single month, month in and month out. This is called "dollar cost averaging" and over time, it will boost your portfolio's performance, even when the stock market fluctuates.

THE BOTTOM LINE: Saving for retirement is the biggest financial job of your life. Don't take it on without a clear idea of exactly what you want to achieve.

Getting the Proper Credit

Question of the week:My brother-in-law orders a copy of his credit report every single year, but I've never even seen mine. Does it really matter all that much? --Dianne T.

Dear Dianne,

It's a good idea to periodically check on the accuracy of your credit reports. This is especially important if you're considering a major purchase, like a home or a car. Checking in advance on the accuracy of your information could speed the credit-granting process.

When we asked members of the Armchair Millionaire community about checking their reports, we heard a range of good reasons for checking your credit. Here are some examples:

"I check mine every two years and look for obvious errors. This is also a good time to close those accounts that are still open that you do not use anymore." --Paul K.

"We routinely find minimal mistakes on our credit reports, like wrong addresses or incorrect employers. We've even found incorrect account information or loans which were still being reported as open, even though they were actually paid in full and closed." --Jennifer G.

"I was a victim of credit fraud years ago. I have checked my report from all three bureaus on a regular basis ever since." --Jose R.

Since you've never obtained your credit report before, my guide provides you the basics on how to get it and what you'll find on it.

The Armchair Millionaire Guide to Credit Reports

• Getting your report. You can order a copy of your report through the Web sites of each of the three major credit reporting agencies:
  • Equifax (www.equifax.com)
  • Experian (www.experian.com)
  • TransUnion (www.transunion.com)
  Since more than one agency may have a file on you, with different information, you may want to contact each one. In most cases, you'll pay $9.00 per report, although depending on situation, the report may cost slightly less, or even be free

• What's on your report. There are four kinds of information:
  • Identifying information. This means your name, current and previous addresses, Social Security number, year of birth, employment history and income, and home ownership.
  • Credit information. This is your record of paying back loans and credit cards. It includes the date you opened each account, your credit limit or loan amount, balance, monthly payments and payment record over the past several years. If you've had an overdue account referred to a collection agency, that would be included here, as well.
  • Public record information. This includes bankruptcies, tax liens judgments, and any other information available from public records.
  • Inquiries. These are the names of those who have requested a copy of your credit report.

• Where the information comes from. It comes from a wide variety of sources: banks, credit card companies, mortgage and finance companies, credit unions, commercial lenders, and department stores, local merchants, landlords, insurance companies, utilities, hospitals, doctors, lawyers and other professionals. It is also gathered from the public records of municipal, state and federal agencies, land record offices and other government agencies.

• Who gets to see it. The Fair Credit Reporting Act sets the rules about who has access to your report. It's generally limited to people you have initiated business with, such as landlords, lenders and credit card companies, who have a "permissible reason" to see your report. Employers and prospective employers can also see it, provided you've given them written permission to do so.

THE BOTTOM LINE: Because your credit file changes constantly, it's important to review it from time to time to check that it's correct. This is a basic financial housekeeping chore that everyone should take care of on a regular basis.