Updated on April 4, 2008.>
UP UNTIL RECENTLY, getting a student loan was a relatively easy process. But given the subprime mortgage mess and the turmoil in the financial markets, all of that changed. Student loan lending companies are tightening lending requirements and making it harder for students especially those with less than stellar credit to get their hands on an affordable loan. Interest rates on private student loans, for example, recently increased by 0.25% to 3.0% for borrowers with bad credit, according to Mark Kantrowitz, publisher of FinAid.org.
This spells bad news for incoming and current college students. After all, student loans have become an unavoidable part of the college experience. In 2006-2007, about three quarters of undergraduate students receiving some form of financial aid, according to the College Board.
So if you've got college-bound kids, chances are you or your children will have to take on debt to pay the college bills. And while shopping for the federally guaranteed Stafford and Perkins loans is relatively straightforward the financial aid office basically sets the limit on how much you can borrow and the government determines the interest rates shopping for a private education loan is an entirely different thing.
Why? Because private lenders are free to set the loan terms including the fees and interest rates as they wish, and then don't have to disclose these terms until you send in your application. "It's hard to compare apples to apples before you actually apply," says Mark Kantrowitz, publisher of FinAid.org, an online financial aid resource.
At the same time, private loans which are typically used for covering a student's unmet need, or that part of the bill that isn't covered by financial aid are becoming harder to avoid. (PLUS loans, which are federally guaranteed loans designed for undergraduate students' parents and for graduate students, are another way to bridge the need gap; we'll discuss more below.)
"As tuition costs have continued to rise and federal loans have not kept pace, we've seen an increase in private education loans," says Martha Holler, spokeswoman for education lender Sallie Mae. In 2006-07, 24% of all educational loan volume was private loans, according to the College Board, compared with only 8.8% six years earlier.
Below is a guide to uncovering the secrets of private education loans and how to get the best deal.
Like their federally-guaranteed cousins, private education loans can be used for college expenses, including tuition and fees, room and board. And while interest does accrue while you're in school as is the case with unsubsidized Stafford loans no payments are typically due until six months after graduation.
Unlike federal loans, the terms of private loans are set by the individual lenders. Rates are tied either to the prime rate (currently at 5.25%), or to the three-month LIBOR (the rate international banks charge each other for loans, currently at 2.68%).
But because the company runs a credit check when you apply, the rates advertised by lenders aren't necessarily the ones you'll get. Your interest rate is determined by your credit history, your debt-to-income ratio and, with many lenders, by the school you will be attending. (Someone attending Harvard will likely get a lower interest rate than someone attending XYZ College if Harvard's default rate is lower than that of XYZ, according to Mike Reardon, chairman of Citibank's Student Loan Corporation.)
These days, the best student loan offers have rates of LIBOR + 1.8% or prime + 1% (4.48% or 6.25%, respectively), according to FinAid.org's Kantrowitz. But these rates are reserved for the best applicants, he explains. The worse your credit history, the more will be tacked onto the prime rate or the LIBOR, so even though a lender may be advertising loans at 4.48%, you may be offered 11% or higher. If your credit score is lower than 650, or even 680 or 700, chances are you will not qualify for a loan at all. The same goes for fees, which are also based on the applicant's credit and in some cases, the amount of the loan.
The catch: The lenders won't tell you what interest rate or fees you'll get unless you actually apply. This makes shopping around trickier, as each application with a lender affects your credit score and in turn may result in getting lower rate offers by consecutive lenders.
The FICO score treats student loan inquiries the same way it treats credit card inquiries, according to Barry Paperno, manager of consumer operations at Fair Isaac, the company that calculates credit scores. In contrast with mortgage or car-loan applications, borrowers get a 30-day buffer, which means the inquiry will not appear in their credit report within 30 days of applying thus allowing consumers to shop around for the best rate for at least one month. Additionally, auto- or mortgage-loan inquiries made within 45 days of each other are treated by FICO as just one inquiry, allowing you to apply with a large number of lenders without dragging down your score for each consecutive lender. But that's not the case with private student loans. New credit applications have a negative effect on your credit score because lenders view the fact that you're looking for more credit as a risk.
And if that weren't enough, the rate you qualify for while in school may not be what you'll pay once you enter repayment. "Once you graduate, the rate may jump by one or two percentage points," Kantrowitz says. This, however, should be outlined in the paperwork you sign to complete the loan process. Bottom line: Before deciding on a lender, always ask how the rate formula changes in repayment and if there will be any additional fees.
How to find the best deal
There's not much you can do about the interest rates you qualify for, but there are other ways to compare lenders. Here's how to shop around.
Research borrower benefits
Graduate students: You can take a PLUS loan too
of private loan offers updated before the start of each school year.
This is basically how often the amount of accrued interest is added to your loan principal. Some lenders capitalize your interest annually, others do it once a quarter, and some capitalize interest only once you enter repayment. "It can have a big impact on the cost of the loan," Kantrowitz says. The more frequently interest is capitalized, the more you end up paying because you are basically paying interest on interest as it compounds.
Some lenders offer interest rate reductions or principal refunds if you pay your loan on time. With Citibank's private loans, you will receive a 0.25% rate reduction when you sign up for automatic payment withdrawals from your bank account and another 0.50% reduction after you make 48 consecutive on-time monthly payments. Wells Fargo clients can reduce their rate by as much as one percentage point if they select automatic withdrawals and make 48 timely payments. Sallie Mae, on the other hand, offers no borrower benefits for its private loans.
Because your debt-to-income ratio is part of the formula banks use to determine your loan rate, students may want to ask a parent to co-sign the loan so they can qualify for better terms. (That's in the event that the student has no income, of course, a common situation among undergrads. In addition to that, a co-signer with poor credit may not be of much help.)
Just be warned: Once a parent co-signs that loan, they are on the hook should the student fail to repay it. Some lenders offer the so-called "co-signer release" benefit to good customers that allows the co-signer to be taken off the loan after a number of on-time payments. At Wells Fargo, for example, your co-signer is off the hook after you make your first 24 consecutive payments on time.
PLUS loans are federally guaranteed loans available to parents. Thanks to legislation passed by Congress, the rate is a fixed 8.5% until 2012. (It used to be that rates on PLUS and Stafford loans were reset annually.) While this rate is higher than the best rates offered on private education loans, remember that private loan rates are variable and should interest rates continue heading upwards, so will private loan rates.
The only drawback of PLUS loans: Repayment starts immediately, while private loan payments can be deferred while the student is in school.
Graduate students can take out PLUS loans as well. This means you can forego taking out private loans entirely, since PLUS loans carry no borrowing limits. (Students can borrow up to the cost of attendance minus aid received.) An added benefit: Unlike PLUS loans for parents, where payments start immediately after taking the loan, graduate students can defer PLUS repayment while in school.