College

Be Wary of Private Student Loans

Higher interest rates and more-stringent payback requirements could leave your student in a bind.

By Jane Bennett Clark, Senior Associate Editor, Kiplinger's Personal Finance

August 14, 2009

Until a year or two ago, private student loans were the hottest thing on college campuses since sliced pizza. The number of private loans (not to be confused with federal student loans offered through private lenders) more than tripled between 1998 and 2008, rising from 7% of all educational loans to 23%. Then credit seized up and dozens of lenders left the market. Now, the lenders who do offer the loans have made them harder to get and more expensive.

That isn't a bad thing if it prevents student borrowers from loading up on these costly deals. Unlike federal loans, which carry fixed rates and flexible repayment terms, private loans carry variable rates, which typically end up in double digits. They offer little relief for borrowers who have trouble repaying, and they let students borrow up to the cost of attendance (including room and board but minus financial aid), making it easy for them to get in over their heads.

Brittney Taylor knows what it's like to be drowning in student debt. When she graduated from the University of Miami with a master's degree in music business, she walked away with $80,000 in student loans, about half of them private. Taylor can opt for one of several repayment programs that will make her monthly payments on the federal loans more manageable (see How to Repay Student Loans), but she has no such leeway on the private loans.

Lesson? Have your student max out on federal loans first (see the box) and use private loans sparingly, if at all. New rules by the Federal Reserve, which take effect in early 2010, dictate that lenders disclose more and clearer information about rates and fees. In the meantime, here's what to watch out for.

Consider the cosigner. To get a private loan, your student will not only need good credit, but also a creditworthy cosigner-typically a parent. Once, "good" meant a FICO score of at least 680, says Mark Kantrowitz, of FinAid.org. Now, lenders look for a score of at least 680 for the student (or no credit score at all), and 700 to 720 for the cosigner, says Kevin Walker, of SimpleTuition.com.

If you cosign, you are on the hook if your student misses or is late on a payment. You might be better off taking out a PLUS loan (see the box) and asking your student to repay the loan after graduation.

Compare interest rates. Lenders peg the interest rate for private student loans to the prime rate or the LIBOR index, plus a margin, which depends on the applicant's and cosigner's creditworthiness. Some lenders advertise only the low rate, and others cite a range.

Pay attention to the high rate, not the teaser, says Tim Ranzetta, of Student Lending Analytics, an independent research company. "My guess is that no more than 5% to 10% of applicants get the minimum rate." The average starting rate, including the margin, on private student loans has been about 11% lately, he says, but variable rates tend to go up, not down. Figure the rate will rise by about four percentage points over the life of the loan.

Consider the annual percentage rate. Also vet the fees and find out when and how often interest is added to the principal, both of which affect the total cost of the loan. The APR wraps those factors, along with the interest rate, into a single number: "It's much more valuable than just the interest rate," says Walker.

But keep in mind that the APR reflects the cost over the intended life of the loan, and it doesn't let you compare the costs of loans with different repayment periods. (For an apples-to-apples comparison of loans with different life spans, use FinAid.org's loan-analyzer calculator.) Also, the APR changes depending on whether the student is in school or in repayment, so be sure to check both numbers.

Shop the lenders. You won't know the actual rate until you apply, and applying for too many loans over an extended period can hurt your credit score. So identify the most promising four to five lenders and apply to all of them within a 30-day window.

To start, ask the financial-aid office at your student's school whether it provides a list of preferred lenders. (If so, the list must include at least two lenders and provide detailed information about the loans.) Compare lenders and loan terms at FinAid.org and Simpletuition.com. Another site, Studentlendinganalytics.com, rates private student loans by their cost, customer service and other factors.

Read the fine print. When a lender sends you an application to fill out, it must include a promissory note and disclosure statement that spell out the details of the loan-including a breakdown of fees, how late payments are defined, what triggers default, and what options are available to borrowers who have trouble making their payments. You owe it to yourself and your student to understand these documents, says Walker. "It's boring and the language is legalese, but the devil is in the details."

MAX OUT FEDERAL LOANS

Federal student loans represent a better deal than private loans because they carry fixed rates and flexible repayment terms (see "How to Repay Student Loans," at kiplinger.com). Here's a quick rundown on the options. Stafford: fixed rate of 6.8% or less. Maximum total for dependent undergrads: $31,000. Anyone can qualify, but you must apply for federal financial aid to get the loans. Perkins: fixed rate of 5%. Maximum total: $27,500. You must apply for federal financial aid and demonstrate financial need. Grad PLUS: fixed rate of 8.5% or less. Maximum amount: total cost of attendance minus financial aid. A basic credit check is required, and you must apply for federal financial aid to qualify. Parent PLUS: fixed rate of 8.5% or less. Maximum amount: total cost of attendance minus financial aid. A basic credit check is required, and you should file for federal financial aid. If you are denied a PLUS loan, your student can qualify for a higher amount in Stafford loans.

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