Online Extra: The Private-Loan Dilemma

Unable to borrow enough via the federal government, more students are turning to other lenders, which can be a risky last resort

Jesse Beck, an incoming sophomore at liberal arts college Chapman University in Orange County, Calif., worries that a $5,000 scholarship, a subsidized loan, and additional grants still don't total enough to cover his tuition, fees, and housing costs, which add up to $37,000 a year.

A double major in dance and psychology, Beck admits to having trouble seeing a light at the end of the tunnel. "I'd be all right if I were graduating with $150,000 in debt from medical school or law school, but not undergraduate school," he laments.


  Although Chapman provides students like Beck with financial coaching, figuring out how to pay for school still poses a problem on a number of levels. Beck's petition for further federal loans has proved lengthy and complicated.

For example, his parents must be turned down for a federal PLUS loan before he can qualify for another loan. So Beck is looking at a substantial private loan that will most likely have a much higher interest rate than the 4.7% his federal loans carry. He realizes that almost any career he might pursue will require a degree -- so as long as a loan option is out there, he's willing to pay the price.

Beck has plenty of company. Over the last decade, tuition has skyrocketed 44% at public colleges and universities and 35% at private ones. Federal student-loan limits haven't kept pace, and an increasing number of students are using private loans to bridge the gap. Private student-loan volume amounted to $10.6 billion in 2004, a sevenfold dollar increase since 1996, according to the College Board, and it doesn't look like growth is slowing.


  While pending legislation would raise certain federal loan limits slightly -- freshmen Stafford loan limits would increase from $2,625, to $3,500, and sophomore limits from $3,500, to $4,500 -- the overall cap on undergrad loans will most likely remain $23,000, well below what many students need.

Mark Brenner, vice-chairman of College Loan Corp., the nation's No. 7 education lender, predicts that by 2012 private loans will actually overtake the federally guaranteed variety in annual market share. Private loans only constituted 11% of total education loan dollars in 2004. Although College Loan Corp. recently formed a subsidiary, Student Capital Corp., to provide students with custom private loans, Brenner still encourages eligible students to exhaust federal student before turning to private loans.

"I can't think of a scenario where a private loan would be a better option," Brenner says. Federal loans generally carry more-favorable interest rates and terms than private ones, which often require a credit check and co-signer.


  Furthermore, federal recipients can receive subsidized loans that require paying back only the principle plus interest accrued after graduation. They can also obtain deferrals or loan cancellations for taking certain government jobs or for going back to school. And the government forgives these loans if the recipient becomes incapacitated or dies.

Still, a private loan can make an attractive option for students when weighed against a dead-end alternative. "For many students, it has become the difference between attending and not attending college," says Sallie Mae spokeswoman Martha Holler. Sallie Mae, the nation's No. 1 education lender, saw its private-loan portfolio shoot up 33% in the second quarter of 2005, vs. the same quarter a year earlier.

Private student loans also do have some advantages over their federal counterparts. Private options often provide students with greater flexibility in loan-origination fees and repayment terms and conditions. They can also be obtained throughout the year (most federal student loans are available for a limited time each semester), a valuable option for students whose needs exceed their initial forecast. Although co-signer and credit-check requirements complicate the process, the application itself is generally shorter and requires less paperwork than those of federal loans.


  Interest rates on private loans have typically been higher than those on federal loans, because they carry greater lender risk, but in recent years the gap has narrowed, especially for students with a good credit rating or a co-signer.

This especially holds true at schools that don't offer their students federal loans directly and instead rely on private lenders to supply both federally guaranteed and private loans. To encourage a school to include them, lenders will often offer attractive private-loan options (especially for top institutions) that can be packaged with the federal loans in a single repayment plan.

To accommodate demand, lenders have stepped up the number of private-loan options available to students. From 1998 to 2003, the number of different products offered to students increased 244%, to 272, according to higher education business magazine Greentree Gazette. Many of these loans are targeted toward law and medical students, who borrow more money than any other group because of their high tuition costs.


  A downside to this flexibility: It allows for the possibility that the money will end up misused. Lenders worry that students -- especially those in graduate school -- will yield to the temptation to use loans to maintain their less-spartan pre-graduate-school lifestyles. Sallie Mae requires students to sign a promissory note that their loan will go toward educational expenses only and often sends the loan directly to the institution itself.

For cash-strapped undergrads like Jesse, though, often the biggest problem is securing a loan in the first place. Many haven't yet established good credit, and the majority of private loans require a credit check. And even if "credit-risk" students manage to procure a private loan at a high interest rate, a low-paying first job could mean that monthly student loan repayments gobble up 50% of their salary.

Nevertheless, private loans have proven a valid option for students facing the increasing financial demands of higher education. But it's important that students go into the process with both eyes open -- as well as their wallets.

By Lindsey Gerdes in New York

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