Private student loans pose greater risk

When Jeremy Hynd graduated from Vanderbilt University in 2004, he applied to consolidate $44,000 in student loans. With interest rates then at record lows, consolidation offered the opportunity to lock in a 2.5% rate for the life of the loan.
But Hynd discovered that $27,000 of his loans weren't eligible for federal loan consolidation because they were private student loans. The rates on the two private loans have since jumped to 8.7% and 11.7%, from 5% and 8%, when he was in school. Hynd, 24, an analyst for Sony Pictures Television in Los Angeles, recently took on a second full-time job so he can pay off his private loans as quickly as possible.

Private loans are the fastest-growing sector of the multibillion-dollar student loan industry. In 2005-06, college students borrowed a record $17.3 billion in private loans, up 913% from a decade ago, according to a report issued Tuesday by the College Board.

Unlike federal student loans, private loans aren't guaranteed by the federal government. While guaranteed student loans carry a fixed rate of 6.8%, there are no limits on the interest rates and fees private lenders can charge. Some have variable rates of up to 19%.

Once primarily used by graduate and professional students, private loans are becoming increasingly popular with undergrads. Nearly 85% of private loans provided by student lending giant Sallie Mae go to undergraduate students, up from 72% five years ago, says Barry Goulding, a Sallie Mae senior vice president.

While federal Stafford loans are available to all students regardless of their credit history, private lenders check a borrower's credit report before making loans. Students who have no credit history, or poor credit, will typically pay higher rates than those with a good credit history or those with a parent who will co-sign the loan. As a result, the poorest students end up with the most expensive loans, says Luke Swarthout, associate at the State Public Interest Research Groups' Higher Education Project.

"It works entirely counter to our financial aid system, which is intended to provide access and affordability with a particular eye to students who are least able to pay," Swarthout says.

Some major lenders that provide federally guaranteed loans, such as Sallie Mae and Citibank, also offer private loans. Other lenders, such as EduCap, specialize in private student loans.

Behind the rise in private borrowing:

1 Limits on federal

student loans.

The total amount undergraduates who are dependents can borrow through the federal Stafford loan program is $23,000, an amount that hasn't changed since 1992. During the same period, the average annual cost of college tuition and room and board at public, four-year colleges has risen 135% to $12,796 this year, according to the College Board.

In addition to the overall limit, there are caps on the amount undergraduates can borrow each year. On July 1, 2007, the amount of Stafford loans college freshmen can borrow will rise to $3,500 from $2,625, while limits for sophomores will increase to $4,500 from $3,500. But that's still well short of the annual cost of attending many private — and even some public — colleges.

The amount of aid available for low-income students has also stagnated. The maximum Pell Grant, the most common form of direct federal aid for low-income students, is $4,050, a sum Congress hasn't raised since 2003. The most available under the Perkins program, which provides low-interest loans to students with "exceptional" financial need, is $4,000 a year.

As a result, private loans "have become a necessity for a lot of families," says Jerry Cebrzynski, financial aid director for Lake Forest College in Lake Forest, Ill.

Natalie Jones, a sophomore at Northeastern University in Boston, has borrowed the maximum available under the federal Stafford program, and she also won some scholarships. Still, she fell far short of what's needed to pay Northeastern's $40,000 annual tuition and room and board. In her first two years of college, she's borrowed about $39,000 in private loans.

Because Jones' mother, DeLaine Jones, co-signed for the private loans, the interest rate is 7.25%; without a co-signer, it would have been 8.25%. There's no guarantee, though, that the rate won't rise.

Jones, a communications/business major from Apple Valley, Minn., wishes she could borrow more from the federal program but believes the education she's getting is worth the cost of private loans. "I feel I fit into this school," she says. "I'm proud of the fact that I'm getting a private education.

2 Aggressive marketing.

A borrower who plugs "student loans" into an Internet search engine will find dozens of links to student lenders. Many of them promise to approve $50,000 or more in student loans in 15 minutes. Others say they can deliver loans faster and more efficiently than the federal loan program can.

Such claims have led to charges that some private lenders are misleading students. Last month, the United States Student Association, an advocacy group for college students, filed a complaint with the Federal Trade Commission. The association charged that advertising by Loan to Learn, a private lender, tries to discourage borrowers from applying for federal student loans. The advertisements also suggest that the company's loans are a better alternative, the USSA argued.

"There has been a lot of confusion, and I feel students have been deceived in many different ways," says Jennifer Pae, president of the association.

Officials at EduCap, Loan to Learn's parent company, contend that the complaint mischaracterizes the materials it provides potential customers. "We encourage families to take advantage of all government financial aid programs they're eligible for before seeking assistance from lending organizations such as ourselves," says George Pappas, a senior vice president at EduCap.

Many students, though, aren't getting the message. A 2003 analysis by the Public Interest Research Groups found that nearly half of undergraduates with private loans did not first borrow the maximum available from the Stafford program. About a quarter of those students bypassed the federal loan program entirely.

Robert Shireman, director of the Project on Student Debt, says some borrowers might not understand the difference between federal and private loans, which are often provided by the same lenders.

Students may also be intimidated by the application forms for federal loans — a fear, Shireman says, that some private lenders exploit.

Borrowers "are drawn to the easy, quick, '30 seconds and you'll be approved' type of approach we're seeing more and more of now," Shireman says.

3 Financial pressures on parents.

Parents of undergraduate students can supplement their children's aid and loan packages with a federal Parent Loan to Undergraduate Students, or PLUS loan. PLUS loans carry a fixed rate of 8.5%.

The credit standards for these loans are less stringent than those for private loans, and parents can borrow up to the full cost of college.

But parents are increasingly reluctant to borrow for their children's education, lenders and financial aid directors say. Over the past decade, the amount borrowed from the PLUS program has grown at a far slower rate than the amount borrowed from private lenders.

"We're seeing a new generation of parents who want their students to take charge and be liable for their education cost," says Cebrzynski of Lake Forest College.

Parents in their 40s and 50s are "at a place in their life where they're trying to balance the desire to help their son or daughter with education and planning for retirement, and they're really torn," says Sallie Mae's Goulding. Instead, he says, they tend to co-sign a private loan taken out in a student's name.

Co-signing typically provides more favorable rates for student borrowers, but it doesn't get parents off the hook. If the borrower can't make payments, the parents who co-sign are then responsible.

John Bowie, financial aid director at the University of New England in Biddeford, Maine, points out that because current interest rates are relatively low, rates on many co-signed private loans are lower than PLUS loan rates. But he worries that some borrowers might not realize that private loans are like adjustable-rate mortgages: If interest rates rise, the rates on their loans will go up, too.

"If I were a parent, I would do a PLUS before a private loan," Bowie says.

Loans for life?

Private lenders insist the long-term benefits of a college education are worth the extra cost of a private loan. "Even if it's at a slightly higher rate, it still helps the students pull themselves up and live the life they want to live," EduCap's Pappas says.

But if borrowers are unable to find well-paying jobs, they could run into serious financial trouble. Borrowers who are unemployed or suffering economic hardship are entitled to defer payments on their federal loans for up to three years.

Private lenders aren't required to offer hardship deferments, though some do so voluntarily.

In addition, a provision included in the stricter bankruptcy law that took effect last year makes it nearly impossible for borrowers who file for Chapter 7 bankruptcy to erase private student loans. Under the law, borrowers with private loans must show "undue hardship," the same strict standard that applies to federal loans.

Borrowers must convince the court that they'll never earn enough money to repay the loan — an unattainable standard unless the individual is permanently disabled, bankruptcy attorneys say.

Sallie Mae officials say that provision was needed to encourage lenders to offer private loans at reasonable rates.

"It's a loan being made to borrowers with no income, no near-term job prospects and no collateral," Goulding says. Giving additional bankruptcy protection to lenders, he says, "makes common sense."

Consumer groups counter that providers of private student loans don't deserve special bankruptcy protection, because there are no limits on the fees or interest rates they can charge borrowers. And because these loans lack protections included in federal loans, some borrowers could spend the rest of their lives paying off high-interest student loans, they say.

"The assumption is these people won't get stuck because college always works out financially," says Deanne Loonin, an attorney for the National Consumer Law Center. "I think that's a flawed assumption."

Jeremy Hynd, the analyst in Los Angeles, says income from his second job has enabled him to cut the balance on his private loans to about $21,000. But to do so, he's had to work 80 hours a week.

"I'm hoping, if I can keep doing it, I can get it paid off within two years," he says. "Hopefully sooner."

Private student loans pose greater risk


By Sandra Block, USA TODAY