Getting Smarter on School Loans

As private lenders bail, more students will turn to federal funds, which offer better rates and terms

For years, college students and their parents have relied heavily on credit cards, home equity, and private loans to pay for school, according to a recent survey provided exclusively to BusinessWeek. But those sources of cash are drying up. On Aug. 6, Wachovia (WB) joined the more than 150 financial firms that have fled the private student-loan business. And Morgan Stanley (MS) froze home-equity lines for some clients.

In a weird way, the credit crunch may be an important wake-up call for some families who had been financing tuition costs in irrational and expensive ways during the era of easy money and rapidly rising home prices. The growing skittishness of lenders will force more borrowers to exhaust their federal options, a growing pool of funds that typically have lower interest rates and more favorable terms. The fixed rates on a government loan run from around 6.8% to 8%, compared with an adjustable 8% to 20% for a private one. The average credit-card rate tops 13%. "There's a lot of hysteria that the turmoil in the credit market will mean students can't get loans," says Robert Shireman, president of advocacy group Institute for College Access & Success. "But students should be thinking really hard about whether they should be taking out private loans in the first place."

The Cost of Convenience

A forthcoming survey by student-lending giant Sallie Mae (SLM) and research firm Gallup reveals for the first time just how heavily families have depended on those costly forms of credit. Although 77% of students and 36% of parents tapped into federal funds, both groups usually turned to other sources to supplement that money—sometimes unnecessarily. Some 19% of parents who borrowed money charged tuition on a credit card, while 20% relied on home-equity loans, taking out $10,854 on average. More than one-fourth of the students who used plastic did so merely out of convenience.

Private loans have blossomed as well, growing 27% a year from 2001 to 2007, vs. 7% for federal ones, according to nonprofit education firm the College Board, which administers the SATs. Lenders made the process easy, often requiring consumers to do little more than make a phone call or fill out a basic online form. Financial aid officers played a part, too, sometimes referring bewildered parents to private lenders—a cozy relationship that was investigated by the New York Attorney General. Several financial aid officers at major universities, who allegedly got kickbacks for steering students to certain lenders, resigned amid the scandal in 2007. "Private lenders were very savvy about marketing to students," says Paula Lull, assistant vice-president at Chicago's DePaul University.

In comparison, the government-loan process seems cumbersome. The federal aid form, known as FAFSA, has roughly 110 questions, probing deeply into a family's assets and earnings. Students need reams of documents and tax forms to complete the FAFSA, and parents must reveal sensitive financial details. The Sallie Mae/Gallup study found that 25% of borrowers didn't even fill out the FAFSA paperwork.

But with financial firms now beating a hasty retreat from all manner of lending, the federal coffers—as much as taxpayers might cringe—remain one of the few places students can find cash. A big exception: students at community colleges and for-profit or vocational schools, which don't typically participate in the federal lending program.

To help, Congress has been expanding the federal safety net in recent months. In July lawmakers upped the limits on Stafford loans, the primary type of federal loan, which are available regardless of family income and credit history. Students can now get an extra $2,000 a year, bringing the four-year total to $31,000 for those still dependent on mom and dad, and $57,000 for those who are supporting themselves.

A Break for Homeowners

Congress has also made it easier to qualify for PLUS loans, a federal option for parents. Such loans require a credit check. But in the wake of the subprime mess, the government no longer penalizes potential PLUS borrowers for missing a mortgage payment. And if parents with shaky credit are rejected for a PLUS loan, the amount of funds available to their kids through a Stafford nearly doubles. "Students will likely apply for private loans and strike out," says Anna Griswold, executive director of student aid at Penn State University. "That will force them to get informed about their other options."

The learning curve will be steep for many families, who often don't know the pros and cons for the different types of student loans. For example, some private loans offer low appealing teaser rates that jump higher within months; federal funds are locked in at 6.8% for a Stafford and 8% for a PLUS. And with government-backed loans, students can defer payments if the costs prove too burdensome. "Students and their parents have so many misconceptions about federal loans," says DePaul's Lull.

Some colleges are trying to fill that knowledge gap. With students racking up high-cost debt, New York's Barnard College now requires families to speak with a financial aid officer before it will certify a student's enrollment—proof of which is required to get an education loan. During one recent meeting, recalls Barnard's director of financial aid, Alison Rabil, the mother of an incoming freshman, initially didn't want a PLUS loan. The parent, says Rabil, assumed she would have to start repaying the money within 60 days of receiving the last check. When Rabil informed her of the possibility of an extension, she ditched the private loan for a PLUS.

Barnard's efforts have had a noticeable impact. Since the program started two years ago, its volume of private loans has dropped from $1.5 million to $435,000. "We explain to parents that private loans are like a well-priced credit card," says Rabil. "The federal options are always going to be better—parents just need to be aware."

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