Where Financial Aid Comes From

The following is a breakdown of the sources of financial aid:

Aid administered by colleges:
Federal Aid 66%
State Aid 6%
College Aid 19%
Subtotal: 91%

Aid administered by others:
Employer Provided 6%
VA Program 2%
Private Scholarships 1%
Subtotal: 9%

TOTAL: 100%

Types of Financial Aid

There are three types of financial aid:

  1. Grants and Scholarships
  2. Subsidized Loans
  3. Work-Study

Grants and Scholarships

  • Federal Pell Grants

A Federal Pell Grant ranges up to $5,920. This is need-based aid. Undergraduate students in four-year programs may receive a Pell Grant for up to six years. A student with a bachelor’s degree is ineligible to receive a Federal Pell Grant.

Note: Pell Grants will not be reduced by the athletic scholarships when determining the permissible amount of financial aid for student athletes. Therefore, both NCAA Division I and II colleges allow student athletes to receive Pell Grants without any regard to cost of attendance restrictions.

  • Federal Supplemental Educational Opportunity Grant

A SEOG (Federal Supplemental Educational Opportunity Grant) is a grant (priority given to Pell Grant recipients) ranging up to $4,000. The college determines the amount that a student receives of this federal grant. This is need-based aid. A student with a bachelor’s degree is also ineligible to receive a SEOG Grant.

  • College Scholarships/Grants

College Scholarships are given to students with merit as well as need. Colleges derive the funds for these scholarships from their endowment funds or by giving a tuition discount.

Observation: “Tuition Discounting,” a practice that few colleges will admit to the public that they practice, is commonplace among colleges. Tuition discounting is merely reducing the “sticker price” of a college in order to attract students to fill the college’s enrollment needs. A study by the National Association of College and University Business Offices found that, depending on the size and tuition level of the school, 60% to 82% of freshman were receiving some form of institutional grant that reduced college tuition by 28% to 38%.

College tuition discounts are often non-need based and are used to lure students with special talents or merit to the college. This type of financial aid is becoming more prevalent across the U.S. for affluent families who do not qualify for need-based financial aid. Consequently, it is becoming increasingly important for college financial advisors to explore this type of financial aid for affluent families.

Note: A Student may be able to exclude all or part of a qualified scholarship or grant they receive from their gross income if the following criteria are satisfied:

  • The student must be a candidate for a degree,   
  • The monies received from the scholarship or grant must be used to pay for tuition and fees, books, supplies, or equipment required for the courses at the educational institution.

If the money received from the scholarship or grant is used to pay for room and board or other expenses, or if the amount received is for services performed at the school, then it must be included in gross income as earned income, not subject to social security tax. The value of room and board that a student receives as a scholarship that is included in gross income, is also considered to be earned income.

  • State Grant

A State Grant is a grant given by a state. The criteria for these grants vary by state. In some states, the amount of aid available in these programs is substantial. The criteria to qualify for the individual state’s program varies among states. Therefore, it is imperative for the financial advisor to be aware of the criteria for a specific state. The state’s Higher Education agency can provide information on the criteria.

College Loans

  • Federal Subsidized Stafford Loans

Federal Subsidized Stafford Loans are fixed rate (4.45%), need-based loans. A student can borrow $3,500 for the freshman year, $4,500 for the sophomore year and $5,500 for junior, senior and higher years. The interest is paid (subsidized) by the federal government until six months after the student leaves college. Stafford loans carry both life and disability insurance on the student. If the student dies or becomes disabled the loan balance is forgiven. These loans are in the student’s name and the student will be entitled to the student loan interest tax deduction.

  • Federal Perkins Loans

Federal Perkins Loans are low interest need-based loans (the rate is fixed at 5%) ranging up to $5,500 per year. The interest is subsidized by the federal government until six months after the student leaves college. The college determines which students will receive this loan and the amount of the loan. These loans are in the student’s name and the student will be entitled to the student loan interest tax deduction.

  • Federal Unsubsidized Stafford Loans

Unsubsidized Stafford Loans are not need-based loans. If there is no financial need, the student can still receive an Unsubsidized Stafford loan (subject to the Subsidized Stafford loan limits). A student must file a financial aid application to receive this loan. The interest rate (4.45%) and repayment terms are the same as the Federal Subsidized Stafford loan. However, the interest is not subsidized by the federal government during the time the student is in college. Therefore, these loans cannot be considered financial aid when comparing financial aid award letters from various colleges. However, repayment of these loans will not start until six months after the student leaves college.

Note: The Financial Aid Administrator has the authority to determine that the parents are “precluded by exceptional circumstances from borrowing a PLUS loan.” The student can then borrow a Federal Unsubsidized Stafford loan up to the independent student limit. The regulations do not give an all-inclusive list of situations but gives several examples of what might be considered “exceptional circumstances” that might justify an FAA exercising their authority. The items listed are “student’s parent receives only public assistance or disability benefits, the parent is incarcerated, the parent has an adverse credit history, or the parent’s whereabouts are unknown.”

When the student leaves college and claims himself/herself on the student’s tax return, the income will probably be lower than the income phase-out limits for deducting the student loan interest. The student can then deduct the interest paid on the Unsubsidized Stafford loan.

Since the interest accrues during college years and repayment is deferred until after college years for an Unsubsidized Stafford loan, the student will be eligible for a substantial student loan interest deduction. The parents’ income level may be greater than the interest deduction phaseout limit ($150,000 for married) and therefore, they will be unable to deduct any of the interest for the PLUS loan on their tax return.

Note: A college or university has the right to refuse to certify a loan application or to certify the loan for less than a student is actually eligible to receive. As long as the college presents its reasons and explains them in writing, its decision is final.

Note: For a student who is in the process of declaring bankruptcy, the college cannot use the bankruptcy as a reason for denying a loan.

  • Federal PLUS Loans

Federal PLUS (Parents’ Loans for Undergraduate Students) Loans are not need-based loans. The borrower pays the interest and repayment begins 60 days after the student begins school. However, if the parent is enrolled in college on at least a half-time basis, the repayment may be deferred while the parent is in college.

The interest rate on Federal PLUS loans is fixed at 7.00% for loans disbursed after July 1, 2017. If a parent is not credit worthy and cannot obtain a PLUS Loan, the student can borrow an additional $4,000 per year in Unsubsidized Stafford loans for the first and second years of college and $5,000 for the third, fourth, and fifth years of college (the limit for an independent student). The amount of a PLUS Loan that a parent can borrow is limited to the COA minus the financial aid award offered to the student. The amount of financial aid offered to the student does not include Federal Perkins loan or college work-study funds that the college determines the student has declined. In other words, the amount of declined Perkins loan or work-study does not count as part of the student’s financial aid offer when determining eligibility for the PLUS loan.

Graduate and Professional students are now eligible to take PLUS Loans in their names. Like parents under current law, these students will now be authorized to borrow up to the cost of attendance minus other aid received.

These are signature loans in the parent’s name. If the signatory parent (only one parent must sign for the loan) dies or becomes disabled before the loan is repaid, the remaining loan principal balance is forgiven. PLUS Loans may be consolidated into one loan and repaid over a period of up to 30 years.

Example: If the COA at a college was $25,000 and the amount of financial aid offered was $12,000, the parents would be eligible for a $13,000 PLUS loan. If the financial aid offer of $12,000 contained a $2,000 college work-study award and the student declined the work-study portion of the aid offered, the parents would then be eligible for a $15,000 PLUS loan. However, if the student was offered no financial aid because the student demonstrated no financial need, the parents would be eligible for a $25,000 PLUS loan.

Note: There is a special PLUS loan situation where the parent cannot borrow a PLUS loan because of a poor credit rating. In this situation, the dependent student is eligible for an additional unsubsidized Stafford loan. The limits for this loan are the same as for an independent student ($4,000 for the first and second years and $5,000 for the following years). The student has to provide the college with a copy of the parent’s rejection notice to document the reason why the student is receiving an additional unsubsidized Stafford loan. The documentation proving that a parent cannot borrow a PLUS loan should include:

  1. A letter of denial of a PLUS loan from a lender based on a certified application, or
  2. Documentation that indicates that a lender who generally makes a PLUS loan to a parent of a student enrolled at the school would not make a PLUS loan to the parent under circumstances that are applicable to that parent. For example, the student’s parent is dependent on public assistance and the parent cannot now, or most likely in the future, be capable of repaying the loan.

Note: Only the parent or stepparent may be able to take out a PLUS loan. A legal guardian cannot take out a PLUS loan unless it is permitted by the school.

This is not a “professional judgment” situation for the financial aid officer. The student cannot be denied these additional funds unless the financial aid officer refuses to certify the student’s unsubsidized Stafford loan. Furthermore, the college cannot require the other creditworthy parent to borrow a PLUS loan. If the parent who was rejected for the PLUS loan applies for a PLUS loan in a subsequent year and is again rejected, the student is again eligible for unsubsidized Stafford loans.

Note: Since the interest is not subsidized, PLUS loans cannot be considered financial aid. The terms of a PLUS loan may be favorable but they still should not be considered financial aid when the student is comparing financial aid award offers from various colleges. Many colleges will incorrectly include PLUS loans in their financial aid award offers.

Observation: If the student will be attending a college that assesses home equity, a home equity loan may be preferable to a Federal PLUS loan. The home equity loan will reduce the value of the home. In addition, the interest on the home equity loan is not limited to $2,500 and by the client’s AGI.

Note: Borrowers are permitted to get deferments when they are serving in the military during war or other national emergency periods for Stafford, PLUS, and Perkins Loans.

  • Federal Loan Repayment Plans

There are various types of repayment plans for federal loans:

Standard Repayment Plan

This plan requires a fixed amount each month–at least $50–for up to 10 years. The length of the actual repayment period depends on the loan amount.

Extended Repayment Plan

This plan allows an extended loan repayment over a period that is generally 12 to 30 years, depending on the loan amount. The monthly payment may be lower than it would be if the same total loan amount were repaid under the Standard Repayment Plan. However, the total amount of interest, over the life of the loan, may be higher because the repayment period may be longer. The minimum monthly payment is $50.

Graduated Repayment Plan

With this plan the payments are lower at first and then increase generally every two years. The length of the repayment period generally ranges from 12 to 30 years, depending on the loan amount. The monthly payment may range from 50% to 150% of what it would be if the same total loan amount were repaid under the Standard Repayment Plan. However, a higher total amount of interest is paid because the repayment period is longer than it is under the Standard Repayment Plan.

Income Contingent Repayment Plan

This plan bases the monthly payments on yearly income, family size, and loan amount. As income rises or falls, so do the monthly payments. After 25 years, any remaining balance on the loan is forgiven, but taxes may have to be paid on the amount forgiven.

Income-Sensitive Repayment Plan

This plan bases the monthly repayment on yearly income and loan amount. As income rises or falls, so do the monthly payments. Each of the payments must at least equal the interest accrued on the loan between scheduled payments.

  • Consolidation Loans

A Consolidation Loan is designed to help student and parent borrowers simplify loan repayment by allowing the borrower to consolidate several types of federal student loans with various repayment schedules into one loan. Even one loan can be consolidated into a Direct Consolidation Loan in order to get benefits such as flexible repayment options. If the borrower has more than one loan, a Consolidation Loan simplifies the repayment process because there is only one payment per month. Also, the interest rate on the Consolidation Loan may be lower than what is currently being paid on one or more loans. If a federal education loan is in default, a Consolidation Loan may be received only if specific conditions are met.

Observation: Be warned, however, that the rate on a re-consolidated loan will probably not be the rock-bottom consolidation rates currently being advertised. Lenders determine the rate on re-consolidation student loans based on the average rate of the borrower’s underlying loans, weighted by loan size. The fixed rate of the consolidation loan will dominate the rate the new loan will be.

A lender may not refuse to consolidate a loan because of:

  • the number or types of loans to be consolidated
  • the type of school attended
  • the interest rate that would be charged on a consolidation loan
  • the types of repayment schedule available
  • Federal Loan Deferment

Upon graduation from college, assume that several students find that they cannot immediately find a job or the job they do find is low paying. If this situation arises, can the student loans be deferred? The answer to this question is yes, if the student qualifies.

The student qualifies for deferment of the student loans when the student meets one of the following four criteria:

  1. The student must be enrolled at least half time at an institution that meets the eligibility requirements for a particular loan.
  2. The student must be enrolled in a graduate fellowship program or a rehabilitation training program for the disabled.
  3. The student must be unemployed (for up to three years) but actively seeking employment.
  4. The student is facing economic hardship (for up to three years). Economic hardship includes a broad range of reasons that enable the student to defer the loans.

Observation: A borrower may be able to bankrupt out of a federal loan only if the court allows it, because of excessive hardship of repayment. This is very tough to show and most courts will not let the borrower bankrupt out of the loan.

The Perkins loan program provides for deferment of loan repayment. Perkins borrowers (except hardship) also get a six-month grace period following deferment.

Loan forgiveness for the Perkins loan may be obtained if the student is employed in one of the following services:

  • Full-time teachers teaching a “shortage subject” or serving children with disabilities or low-income students or pre-schoolers.
  • Full-time law enforcement officers or correction officers.
  • Nurses or medical technicians.
  • Full-time social services employees serving low-income children and families.
  • Military personnel serving in “areas of hostility.”
  • Peace Corps or ACTION volunteers.
  • Health Education Assistance Loan (HEAL) and Health Professional Student Loan (HPSL) borrowers engaged in similar service or “shortage” activities.

The procedure for obtaining a loan deferment is simple. Before the first payment is due, the loan officer who made the loan must be notified. Then complete and return the paperwork the loan officer sends to the student.

The periods of deferment are not included in the number of years allowed for repayment. Interest will not accrue in the deferment periods if the type of loan the student is deferring did not accrue interest in its original loan period (e.g., Subsidized Stafford or Perkins Loans). However, if the type of loan being deferred did accrue interest in its original loan period (e.g., PLUS Loans), the interest will accrue throughout the deferment period.

The rules for consolidated loans are the same as the above rules. The exception is that if the consolidated loan contains one or more loans that would accrue interest in the original loan period, the entire consolidated loan will accrue interest during the deferment period.


  • Federal Work-study

Federal Work-study is an 8-15 hour-a-week job at the minimum wage rate. The colleges administer this need-based program.

  • College Work-study

College Work-study is a work program set up by the individual college and can be based on the need or the merit of the student. Each individual college sets its own work variables.

  • State Work-study

State Work-study is a work program set up by individual states.

  • Work-study is not Assessed

Need-based work-study is not assessed in the EFC formula. Therefore, when a student is considering work-study employment versus off-campus employment, the student should factor in to the decision that the work-study income will not affect financial aid eligibility. The employment off-campus could reduce the financial aid eligibility by 50% of the earnings.

Observation: A student can receive unemployment benefits in some cases. There are cases where students completed a work-study job precisely as planned, and then filed for and received unemployment benefits.

Order of Filling Need

The following is the order in which a college usually fills their financial aid award packages:

1. Federal Pell Grant and State Grant
2. Federal Stafford Loan
3. Student resources

Optional (school’s decision):
1. Work-study
2. Federal Perkins Loan
3. Federal SEOG Grant
4. College Grants or Tuition Discounts

It is important to understand the order in which types of aid are given to a student by the college. If the order in which the financial need is filled by the colleges is known, the financial advisor can determine if a certain income or asset strategy will produce loans or grants for the student. Should the income or asset strategy produce only loans instead of grants, the tax consequences or asset penalty consequences may outweigh the client’s need for student loans. The merit of the student is also a factor in determining the order in which the college fills the financial need of the student. Typically the college fills the financial need of a student in the following order:

1. Federal Pell Grant (for those that qualify) and State Grant
2. Academic Competitiveness/SMART Grant (for those that qualify)
3. Federal Stafford Loan
4. “Resources” of the student, such as a private scholarship.
5. Work Study
6. Federal Perkins Loan
7. Federal SEOG Grant (usually for those that qualify for the Pell Grant)
8. College Grants or Tuition Discounts

The order of the last four items may vary depending on the merit of the student and the availability of funds at a particular college. Usually, the more merit the student has, the better the type of financial aid the college offers the student. Keep in mind that the total amount of financial aid given from the above sources will not exceed the financial need of the student.

Alternative Loans for College

For clients who do not have funds currently available for college because their funds are tied up in their business, in high-yielding investments, in retirement accounts, or in their residence, borrowing the funds for college may be a viable college-funding alternative. In this section some types of alternative loan strategies will be discussed.

Personal Residence Loans

A personal residence loan may be a source of funds for college. Although many parents do not want to mortgage their home to pay for college costs, it may be a better source of funds than borrowing on their business assets or from their retirement accounts.

If the client uses a home equity line of credit to fund college, the client will borrow what is needed as it is needed. Therefore, the client will pay interest on only the amount borrowed. The client is usually allowed to make minimum monthly payments. The client can make larger payments after the student is done with college. Since the interest rate is variable, the monthly payments will vary. There may be high loan fees associated with this type of loan.

If the client uses a second mortgage to fund college, the client will borrow a fixed amount. Generally, there is a fixed interest rate and a fixed repayment schedule. Therefore, the client will have a fixed monthly payment amount. Since the client will be borrowing a lump sum, which probably will not be used all at once, the client will be paying interest on money not currently needed. Therefore, the client should consider investing the excess funds in a short-term investment until the funds are needed. There may be high loan fees with this type of loan.

For parents whose income is too high to take advantage of the student loan interest deduction, a personal residence loan can give them an itemized income tax deduction (subject to the phase-out rules for high income). This deduction is not limited to $2,500, as is the case for student loan interest.

The repayment term on residence loans is usually longer than retirement account loans and other types of loans, which makes the monthly payments smaller.

Margin Account Loans

If a client has most assets tied up in stocks, bonds and mutual funds, the client may want to borrow against the investment account rather than sell part of the investment to pay for college. The client continues to receive dividends on the entire account and does not have to pay current income tax on the appreciation of the asset. The loan and accrued interest must be repaid before the stock is sold and the proceeds issued to the client.

Each brokerage firm is allowed to set their own requirements for margin accounts, as long as they are more stringent than the requirements imposed by the Federal Reserve.

The main advantage of the margin loan is that the client can use the assets in a short period of time without selling them. The interest rates may be lower than home-equity loan rates, but margin interest used for personal purposes is not tax deductible, affecting the after-tax rate. Therefore, margin loans provide an alternative short-term source of college financing.

The disadvantage to this type of loan is that if the stock price greatly declines, the client may be issued a margin call, which requires the client to deposit cash or more securities in the account, or the stock has to be sold.

Retirement Account Loans

Borrowing from retirement accounts may be considered as a source for college funding. The advantages of borrowing from these sources are a generally favorable interest rate and repayment terms and ease of obtaining the loan. However, if these loans are not repaid within a certain period of time, usually five years, the outstanding principal balance becomes taxable income and subject to a 10% penalty if the borrower is under age 59 1/2.

Also, if the employee loses a job, the outstanding loan balance may have to be immediately repaid or taxable income occurs. In addition, the borrower gives up the ability to defer tax on the withdrawn assets and may be jeopardizing retirement savings.

Furthermore, even though the retirement fund is earning interest on the college loan, it is foregoing the interest it would have earned had it been invested in a mutual fund at a possibly higher rate of return.

Some retirement plans prohibit or restrict distributions before retirement. However, hardship distributions from 401(k) plans (subject to the 10% penalty) are allowed to meet certain college expenses. Taking a hardship distribution precludes the plan participant from contributing to the plan for 12 months.

Life Insurance Loans

Some clients use life insurance loans as a source of college funding. The client should beware of taking out a life insurance loan. What typically happens when a client takes out a life insurance loan for a long period of time is that the loan balance increases because the client doesn’t pay the interest. Therefore, as the loan value increases, the client’s family gets very little, if any, death benefits. Also, the loan balance can eat up all the cash value and there is no cash left in the policy to sustain it. The policy then terminates unless the client pays back the loan. If it terminates, the client doesn’t have to repay the loan plus accrued interest, but then has to recognize this as taxable income.

If the client is borrowing from the policy for college expenses and doesn’t plan on repayment, the client should only borrow an amount that will not terminate the policy until age 100, taking into account whether interest and premiums will be paid out of pocket or not. The loan is usually paid off on death out of the proceeds. Life insurance loans can give the client an option of paying for college, but the client should beware of the pitfalls of borrowing too much and causing the policy to terminate.

Private Loans

There are loans from private sources that can provide supplemental educational financing for undergraduate and graduate students.

Before obtaining an alternative loan, compare the terms of these loans with other loans, including Federal and State loans, residence loans, and loans from retirement and insurance plans.

Following are some sources of private loans:

  • Educaid (1-800-EDUCAID)
  • Educap (1-800-658-3567)
  • GATE Student Loan Program (www.gateloan.com)
  • U.S. Bank (www.estudentloan.com)
  • Key Education Resources (www.key.com/educate)
  • Massachusetts Educational Financing Authority (1-800-449-MEFA)
  • Nellie Mae LOAN LINK (www.nelliemae.com)
  • TERI Alternative Loan Program (1-800-255-8374)
  • TERI Continuing Education Loan (www.teri.org)
  • Chela Financial (www.chelafin.com)
  • Citibank (www.studentloan.com)
  • Connecticut Student Loan Foundation (www.cslf.com)
  • Sallie Mae (www.salliemae.com)
  • Southwest Student Service Corporation (www.sssc.com)
  • Bank of America (www.bankofamerica.com)
  • Wells Fargo Bank (www.wellsfargo.com/education_center)
  • Simple Tuition (www.simpletuition.com)

Sallie Mae has a “student Plus loan” program called the “Signature Student Loan.” These loans are in the student’s name, but the parents may have to cosign the loan. A co-borrower may be required if the student is a foreign student or a freshman or has no credit history or a low credit rating.

These signature loans can be taken out for up to 25 years and repayment doesn’t start until 6 months after graduation. After the student makes 24 on-time payments, the co-borrower can be removed from the loan. A student can borrow up to $25,000 per year and up to $35,000 per year with a co-borrower. The maximum any one student can borrow is $100,000.

Intra-family Loans

Generally, a disparity exists between the rate of earnings on an investment and the interest rate a borrower must pay on a loan. Loaning money to a child for college costs can offer savings opportunities for both the parents and the child. The parents may be able to both increase their rate of return on investments and assist their child in paying for college. The child may increase cash flow for college, due to the lower interest rate on the loan than could be obtained from other financing.

Note: The interest paid on loans from relatives is not deductible as student loan interest expense.

Both parties can benefit in a situation where the child is in need of college funds but the interest rate is high, and the parents have funds available that are currently invested in a low interest rate savings account.

Example: The parents have $150,000 in their savings account that earns 5% annually. Their child needs $125,000 for college; however, the 9% rate the child needs to pay to a lending institution is higher than the child would like. The parents want to loan the student the money, however, they need the income generated from their savings account to live on. The parties agree on a 7% interest rate on the loan. The parents’ marginal tax rate is 25% and the child’s tax rate is 10/15%. In this case, the parents will have an increase in earnings of $2,500 [(7% – 5%) x $125,000], less the increased tax liability of $625, or a net after-tax increase to cash flow of $1,875. The student will have a decrease in interest expense of $2,500 [(9% – 7%) x ($125,000]. The combined increase in family cash flow is $4,375 ($1,875 + $2,500).

There are many factors that must be present to prove that there is a bona fide loan between related parties:

  • There must be the existence of evidence of debt from one party to the other,
  • A fixed schedule for repayment must be drawn up and followed,
  • There should be interest charged on the debt,
  • Collateral should be requested,
  • A written agreement is suggested, but not required,
  • There should be a demand for repayment of the loan,
  • There should be some sort of proof that reflects the debt,
  • There should be proof that payments are being made,
  • Whether the debtor is solvent at the time of the loan,
  • The payments on the loan cannot be contingent on the occurrence of some future event.

Summary of Sources of Funds

The financial advisor should first attempt to qualify the client for grants and scholarships. The second source of funds that the client should attempt to qualify for is work-study. Work-study allows the student to limit the amount of loans needed to pay for college. The last choice of funds for college should be loans. Fortunately, there are many types of subsidized and unsubsidized government and private loan programs available to the client.

If the related parties follow the factors needed to show that they have a bona fide loan, and the borrower defaults on the loan, the lender can claim a bad debt deduction is they have made a demand for payment. Legal action is not required to show that the lender tried to collect on the note. The loan may be considered worthless if the circumstances show that even legal action would not have resulted in collection of the debt.

While the factors discussed are good proof that there is a bonafide loan between related parties, they are not necessarily needed. If the parties can show that there was actual intent to make payments and the failure to do so was because of an eventual distressed financial condition of the borrower, a nonbusiness bad debt can be claimed. Documentation helps prove a bonafide debt is present.