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Private College Loan Perils

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Private College Loan Perils

Nearly 50% of undergraduate private student loan borrowers fail to exhaust their low-cost federal student loans to finance their college education.
--Consumers Union report

Alison Rabil, the director of financial aid at Barnard College, became concerned one day when she was examining figures on the number of students at the women's college who were taking out private loans.

Rabil and others in Barnard's financial aid office certainly understood why private loans should be a last resort. But the school's parents, even though many were college educated, didn't appreciate the potential hazards of a private loan, which is the fastest growing source of student debt in the country.

Consequently, the school in New York City decided to educate its moms and dads. When Barnard learns that a family is on the verge of assuming a private loan, the school arranges a phone interview with parents. After conversations with Barnard staffers, families often abandon their plan to rely on a private loan. Thanks to Barnard's initiative, according to Inside Higher Ed, an online industry publication, the volume of private loans at the school plummeted by 73%.

If you're not sure why private loans should be a last resort, keep reading. Here is what you need to know:

Private loans charge variable interest rates. Anyone with an adjustable rate mortgage already knows why loans without ceiling caps can be perilous. A loan with runaway payments can wreak havoc on a student's or parents' budget. Many people don't realize that private loan payments, which might initially seem manageable, will change because most private loans include variable interest rates that lack a ceiling cap.

Private lenders can discriminate. Unlike federal loan programs, lenders that market private loans can pick and choose their customers. Families with excellent credit can obtain better starting interest rates than those with average or worse credit histories. The less fortunate borrowers can get saddled with loans as bad as the subprime mortgages that helped smash the housing bubble. The spread between the starting interest rate for stellar customers versus those stuck with the worst rate can be 10 percentage points or more.

What's more, the interest rates and fees of private loans can vary from school to school. Some lenders take into account a school's overall loan default rate. So even if you have a pristine credit history, you could still get punished.

Private loans can be confusing. Many families who end up with a private loan believe they have secured a federal loan. Sometimes they don't even realize the mistake they made until they try to consolidate the debt with federal loans. There are many reasons for the confusion. First, the loan process can be bewildering. And families, after surviving the college matchmaking process, may hardly be in the mood to sort through loan possibilities in the spring and summer leading up to a child's freshman year.

Parents and students just want the cash, and they figure they'll worry about how to pay it back later.

If you're considering a private loan, here is what you should be doing:

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Use federal loans first. Families should not consider private loans, which are also called alternative loans, unless they have maxed out the federal loans, which offer better terms and more flexible repayment options. Federally guaranteed loans provide fixed rates, and everybody -- regardless of their FICO credit scores -- receives the same fixed interest rates.

The subsidized and unsubsidized federal Stafford loans are better alternatives for student borrowers and the PLUS loan is best for parents. If you meet the income qualifications, the federal Perkins Loan is the cheapest.

Many families, however, are routinely snubbing federal assistance. According to the Institute for Higher Education Policy, an astounding 20% of dependent students who have private loans never took advantage of federal loans. Another 19% of borrowers never maxed out their federal loans before embracing the private alternative.

Sadly, there are not enough schools like Barnard that are educating parents about the perils of private loans. Some might assume that Barnard can conduct its education effort because it's small, but Colorado State University has proven that even major institutions can spread the word. At Colorado State, about 20% of applicants for private loans either fail to exhaust their federal loan eligibility or skip filing the FAFSA, which is a requirement for obtaining federal loans. Staffers in the financial aid office at Colorado State call every family that falls into one of these two categories and explain their options.

Cosign the loan. Because a borrower's credit record is so important for private loans, students are at a disadvantage when they apply solo. With little or no history of using credit wisely, they can easily get stiffed with mediocre loans that pass along higher interest rates and fees. A parent who has good credit can avoid this problem by taking out the loan themselves or by cosigning the loan. Most lenders will consider only the highest credit scores among co-borrowers. What's more, the interest rate formulas for cosigned loans are slightly better than those on noncosigned loans for the same credit score.

Don't get tricked by slick marketers. If you've got a teenager who will head off to college soon, lenders are probably stuffing your mailbox with junk mail that makes obtaining a private loan seem as easy as ordering Chinese takeout.

Here's an excerpt from a letter sent by Sallie Mae, the big gorilla in the student lending industry, that I received a couple of months before my daughter began college: "Classes will start again before you know it. Don't let worrying about college expenses ruin your summer…Applying is fast, free and easy. Borrow up to $40,000 a year."

Sallie Mae went on to promise that my husband and I wouldn't have to worry about filling out any federal financial aid forms! Many parents might think that is a plus, but the lender was recklessly providing families with a way to jeopardize their chances for the best financial aid. Parents should fill out the federal form -- FAFSA -- because without doing so, they can't obtain federal loans, which are far preferable.

All the junk mail I received from lenders made private loans seem like the best approach by offering, in the words of one lender, "fast" credit decisions, "quick" renewals, and "easy" online applications. If you haven't been bombarded with these promotions, your child could be getting inundated by Internet pop-up ads touting these loans.

The promises sound great, but the price you pay will be high.

Don't be fooled by branded loans. When students receive their financial aid packages, sometimes they will contain loans that bear the name of the school. Beware of private loans masquerading as school loans that are nothing more than marketing ploys. Students may assume that the school branded loans are more favorable, but these loans typically are just like any other private loan, and in some cases they could be worse.

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Ask intelligent questions. Before committing to a private loan, ask these questions:

• Can I get a fixed-rate loan?
• If the interest rate is variable, is there a cap on how high it can go?
• What percentage of borrowers gets the best rate?
• Do you offer an interest rate discount or a reduction in principal if I make on-time payments?
• Does the discount kick in when I start paying off my loan?
• If the discount isn't immediate, how many months of on-time payments must I make?
• If I miss a payment, is there anyway to recapture the discount?
• Are your discounts guaranteed or could they disappear later?
• If I encounter financial hardship, will you allow me to stop payments temporarily without financially penalizing me?
• Is there a prepayment penalty?
• What index are your loans tied to?

Check your credit. If you're contemplating applying for a private loan, check your credit report. By federal law, you are entitled to a free credit report annually from each of the three major credit bureaus:

Equifax (800) 685-1111, www.equifax.com
Experian (888) 397-3742, www.experian.com
TransUnion (800) 888-4213, www.transunion.com

If something is wrong, you'll want to correct it.

Unfortunately, what the free reports can't tell you is your credit score. FICO, which is an abbreviation for its creator, Fair Isaac Corporation, is the most common credit score. FICO scores range from 300 (abysmal) to 850 (phenomenal). Financial institutions generally require minimum scores of 700 to 720 to qualify for the best loan interest rates and terms. About 58% of Americans recently managed to have a FICO score that was at least 700.

Action Plan

Never choose a private loan unless you have maxed out your federal loans.

If your FICO score is less than 620 to 650, you will generally not qualify for private student loans. Most lenders have five or six credit tiers from 650 to 850 so a 30- to 40-point change in a credit score can have a big impact on the cost of a loan.

If your credit score isn't great, you should definitely try boosting it. Taking this initiative could ultimately save you thousands of dollars if you qualify for a more attractive private loan. You can discover many ways to do just that by reading an excellent book, Your Credit Score: How to Fix, Improve, and Protect the 3-Digit Number that Shapes Your Financial Future, 2nd edition, by Liz Pulliam Weston.

Make timely payments. You never want to court trouble with a lender whether it's a private institution or the federal government. One of the best ways to avoid punitive penalties for missing payments is to sign up for automatic payments through your checking or savings account. Many people mess up when they change residences and fail to receive their bill. Don't expect lenders to be sympathetic.