Loans & Interest Deductions

You may not be able to avoid borrowing some money to help pay for college. Stafford loans and Perkins loans are the two major loan programs that loan directly to students. (A third category, PLUS loans, are loans made directly to parents to help them pay for a child's cost of attending an undergraduate program.)

Stafford loans are either subsidized or unsubsidized loans. Stafford loans are disbursed by a bank or other private lender that participates in the Federal Family Education Loan Program (FFELP). The government may disburse the loan directly through the Federal Direct Student Loan Program (FDSLP).

The amount you can borrow with a Stafford loan depends on whether you are an undergraduate or graduate student. You can also borrow different yearly amounts depending on your year in college or whether you are a graduate student.

Undergraduate students who are dependent on their parents can borrow up to a total amount of $23,000, or $46,000 if independent. Graduate students who are dependent on their parents can borrow up to a total of $65,500, or $138,500 if independent.

The interest rate on Stafford loans is indexed to the yield on 3-month T-bills. The margin on the loan is 1.7 percentage points above the T-bill yield until you graduate. After you graduate, the margin increases to 2.3 percentage points. Stafford loans have a lifetime cap of 8.25%. (This cap may be revised.) With a Stafford loan, you may defer interest payments until the loan's grace period expires. (The deferred interest is added to your loan amount.)

Perkins loans are student loans that the school makes directly to the student with the use of government funds. The federal government pays the interest during school and during a grace period that lasts nine months. The interest rate cap on a Perkins loan is 5%.

To apply for either a Stafford or Perkins loan, as well as any other federal financial aid, you must complete a Free Application for Federal Student Aid (FAFSA).

As a result of the 2001 tax law, you can take a tax deduction of up to $2,500 for interest expense paid on student loans over the entire loan term. (Previously, you were limited to taking a deduction during the first 60 months of the loan term.)

The tax law also increases the income limits for taking this deduction. For taxpayers filing a single return in 2008, your allowable deduction begins to phase out when your modified adjusted gross income (MAGI) reaches $55,000. The allowable student-interest deduction phases out completely when your MAGI reaches $55,000. For married taxpayers filing a joint return, the increased income limits are $115,000 and $145,000, respectively.

To take a student loan interest deduction, enter the amount of the deduction on line 33 of the 2007 IRS Form 1040. (Note: This document is in Portable Document Format (PDF). If you do not have a PDF reader installed on your computer, you can download a version of Acrobat Reader for free at Adobe Systems' Web site.)

If your income falls within the income limits shown above, see IRS Pub. 970: "Tax Benefits for Higher Education" to calculate a partial deduction.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.