The Best Rates on Private Loans

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.

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.

The Basics
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.