Top5 Best Ways to Pay for College Tuition

By Stacey L. Bradford,
Associate Editor, SmartMoney.com

IF THERE'S one expense that causes parents to lose sleep at night, it's that looming college tuition bill.

During the 2007-2008 academic year, the average cost to attend a state school was $13,589. A private university was more than double that at a jaw-dropping $32,307. No matter how hard families try to save, it's nearly impossible to come up with a sum that vast. Fortunately, there are many ways to fund an education. Some options, however, are better than others.

Here are the five best ways to finance your young Einstein's education:

1. Invest in a 529 Plan

It's never too late to save for college. Even a small monthly contribution into a college savings account during the high school years can accumulate into a tidy sum. "If you saved $100 a month for the next four years, you could save $5,773, assuming an 8% return," says Patricia Nash Christel, a spokeswoman for student loan provider Sallie Mae.

Where should you sock away that money? Consider a 529 plan. Run by individual states, these savings accounts allow any potential earnings to grow tax-deferred. Best of all, when money is withdrawn and used for qualified college expenses, the funds aren't hit with federal income taxes.

One caveat: with more than 80 plans to choose from, selecting the right one can be tricky. Some come with larger fees than others and investment performance, or returns, also varies. Since state plans offer residents additional tax advantages, including state income tax deductions, it's always a good idea to research your home state's plan first.

Read our story for more advice on selecting a plan that's right for you. Our calculator will also help you determine how much you should save in your 529.

2. Maximize Your Financial Aid

Even if their child won't be entering college for a few years, parents can take steps now to maximize how much financial aid the family receives later on. The idea is to legally make your bank accounts look as small as possible, says Reecy Aresty, author of "How to Pay for College Without Going Broke." That's because colleges generally expect parents to contribute 5.6% of their total assets (with some exceptions) toward a child's tuition.

Rather than leaving money in a savings or brokerage account, consider paying off all high-interest credit card debt first. That way, when colleges are figuring out how much a family can afford to contribute toward tuition, they don't tap into money that's owed to Visa or MasterCard. In almost every case, parents are financially better off borrowing for tuition since the interest rates on student and parent loans tend to be lower than on credit cards, says Aresty. Parents should also contribute as much as the IRS allows into IRAs, 401(k)'s, or other qualified retirement accounts. Financial aid officers tend not to expect folks to dip into their nest eggs to pay for their kids' education.

Visit our College-Savings Superpage for more advice on saving for college.

3. Look for Free Money

According to Sallie Mae, over 2.9 million private scholarships worth over $16 billion are up for grabs this year. While the majority of scholarships are geared toward high school seniors and college students, kids as young as 14 can also qualify for these awards. Best of all, finding scholarships couldn't be easier thanks to Sallie Mae's search engine and Fastweb, a scholarship search site. Local organizations, such as churches, small businesses and a parent's employer may also offer opportunities. Read our story for more tips on landing a scholarship.

For access to the more than $40 billion in federal and state grants and school scholarships, parents need to fill out the Free Application for Federal Student Aid (FAFSA) during their child's senior year of high school. Since some school grants and scholarships are doled out on a first-come, first-serve basis, it's important to get the FAFSA forms in as close to January 1 as possible. Students applying to private schools may also need to fill out the College Board's CSS/Financial Aid PROFILE for nonfederal aid.

4. Take Advantage of Federal Loans

Sometime before the senior prom rolls around, parents need to determine whether or not they'll be able to afford tuition. The good news: if they fall short, they and their children can borrow the rest of the money in federal and private loans. When deciding between these two loan options, it's always best to start off with the "cheapest money," or federal loans since they carry lower interest rates and have more flexible repayment schedules than private loans, says Patricia Nash Christel, a spokeswoman for Sallie Mae.

Federal student loans come in three forms. The first two, Perkins loans and subsidized Stafford Loans, are doled out based on financial need. Perkins loans carry a fixed interest rate of 5%, which is deferred while the student is in college and for the first nine months after graduation. Subsidized Stafford loans carry a 6% interest rate. While the student is still in school, the government covers the interest payments. Even better: borrowers also don't have to start paying off these loans until six months after they receive their diplomas (or they withdraw from college). The third type of loan is an unsubsidized Stafford, which is available to all applicants. These loans currently carry a bit higher rate of 6.8% and students are responsible for paying all of the interest that accrues during the college years.

Once students have exhausted their lending options, mom and dad can borrow money through the federal Parent PLUS loan program. These loans carry an interest rate of 8.5%. As of July 1, 2008, parents are allowed to either start paying off the loan within 60 days after the final disbursement of funds or six months after graduation. While there are no income requirements for a PLUS loan, those with questionable credit could be turned down.

Read our story here for more on federal loans.

5. Private Loans and Home Equity

There are limits to how much students can borrow from the federal government. Any tuition dollars that still aren't covered (or picked up by the parents with a PLUS loan) can be financed on the private market through lenders like Sallie Mae, Citibank and Chase.

Interest rates for these products vary based on credit score. And thanks to the credit crunch, they're now harder to come by. Students who wish to attain a private loan, will better their chances by getting a parent to co-sign their application. That means parents should try to clean up their credit and boost their credit score during their child's high school years, says Sallie Mae's Christel. (Read our story for the latest on private loans.)

Finally, parents can always tap into their home's equity line of credit, or HELOC, to pay for school. The big advantage to this is that homeowners can write off up to $100,000 in the loan's interest come tax time. The downside, however, can be bleak. If Mom loses her job or Dad has a medical emergency and the family can't pay off the line of credit, they could risk losing the home.

Click here for more on college planning.

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