Private Student Loans Set to Stage a Major Comeback

Recent governmental analysis has shown that about one-fourth of all federal financial aid is directed toward students who attend private, for-profit colleges, even though these students represent just 12 percent of the national college population.

Private student loans are non-federal loans – student loans issued by banks and private lenders, rather than by the federal government.

Private student loans are credit-based loans carrying variable interest rates that can be as much as three to five times as high as the fixed interest rates on federal college loans. Additionally, private student loans don’t generally offer the flexible repayment options and borrower hardship protections offered by federal education loans.

The recent substantial drop in the amount of private student loans being issued can be partly attributed to greater publicity of the drawbacks of these loans in comparison to federal student loans.

Consumer advocates, student groups, and the U.S. Department of Education have campaigned heavily over the past three years for the benefits of low-cost federal college loans over private loans, which the groups maintain are more expensive and higher risk for vulnerable student borrowers, many of whom are financially inexperienced and who may not be aware of exactly what kind of long-term debt burden they’re signing up for.

Private Student Loans Poised to Surge at For-Profit Colleges The student loan default rate among students from for-profit colleges is exceptionally high because these students – a large proportion of whom are low-income, minorities, or returning students – tend to have a harder time translating their for-profit degree into gainful employment, and they’re carrying much more student loan debt than their post-graduation income will allow them to repay.

New proposed federal financial aid regulations seek to rein in what critics of for-profit colleges see as runaway student debt levels by instituting a loan default threshold that would render a for-profit institution ineligible to offer federal financial aid to its students if its students have a sustained high student loan default rate.

A proposed federal “gainful employment” rule would also yank federal financial aid funds from for-profit schools whose students graduate with excessive debt-to-income levels and are unable, in general, to find work – “gainful employment” – that will allow them to earn enough to pay off their student loans.

But in the absence of federal financial aid, private loans remain the financing of choice among students – particularly in the current economy, with home equity, credit card lines, investments, and college savings largely decimated – and some private lenders are readying to fill in the gaps left by the suspension of federal financial aid at ineligible institutions.

According to analysts, large private student loan lenders like Wells Fargo and Sallie Mae will reap the benefits of the proposed federal financial aid sanctions, which are set to go into effect in 2012.

Lingering Recession Forces Students Toward Pricier Private Student Loans The re-emergence of private student loans won’t be limited to just for-profit colleges, however. The rise, fall, and rise-again of private student loans as a part of U.S. students’ long-term financial aid future is tied directly to increases in the costs of college and the failure of federal financial aid to keep pace with the increases.

“Increases in college costs are the primary drivers of increases in student borrowing, especially when need-based grants don’t keep pace with higher college costs,” Mark Kantrowitz, publisher of FinAid.org, told Reuters.

And as the sour economy drags on, students’ need for funding sources to help pay for college will only become greater.

Publicly funded colleges and universities are reeling from a string of spending reductions for higher education and are passing along those losses to students in the form of tuition and fee increases.

“Private student loan volume could grow in the double digits next year because of tuition hikes driven by state budget constraints,” said Michael Taiano, a financial analyst at Sandler O’Neill.

At the same time, a record number of students are seeking a higher education, enrolling or re-enrolling in colleges and universities, stretching the federal financial aid budget thin.

“Federal budgets are constrained by how much in aid they can deliver,” said FBR Capital Markets analyst Matt Snowling. “So the funding gap is going to be filled by private loans.”

As the lender-in-chief for federal college loans, the federal government is also beginning to experience first-hand the impact of a growing number of loan defaults, as a national populace in the midst of a recession and 10-percent unemployment struggles to keep up with its monthly bills.

Recent graduates are leaving school with record-high debt from loans and diminished prospects for employment. Parents who in other years might have helped their children pay for college are finding themselves being turned down for federal parent loans because they have joined the ranks of the unemployed and don’t qualify for the loans based on their own creditworthiness.

All of these factors are re-opening the door to private loans, despite the federal government’s best efforts to steer families from private student loans to federal financial aid options.

Taming Student Loan Debt With Prepayments

Today, two-thirds of college students leave school with at least some debt from college loans. The average debt is approaching $25,000, a figure that includes not just the original amounts borrowed but, for most students, accumulated interest as well.

For students who hold government-issued federal student loans, repayment on those loans won’t begin until six months after graduation, at which point most students will enter a standard 10-year loan repayment period.

Loans That Sit, Getting Bigger

While a student is enrolled in school at least half-time and during the six-month grace period after the student leaves school, even though payments on federal school loans aren’t required, interest on the loans continues to accrue.

If the loans are unsubsidized, the accrued interest will be added to the loan balance and capitalized, and the student will be responsible for paying that interest.

With subsidized federal college loans – which have smaller award amounts than unsubsidized loans and which are awarded only to those students who demonstrate financial need – the government will make the interest payments while the student is in school, in a grace period, or in another authorized period of deferment.

The bulk of most students’ college loan debt will consist of unsubsidized loans – loans that get larger as time goes by and you make your way through college, simply because of the buildup of interest.

Preventing Interest Bloat

As a college student, there are steps you can take, however, to counteract this ballooning of your school loans. There are several ways that you can manage your student loan debt and rein in the added burden of accrued interest charges, both while you’re in school and after graduation.

Seemingly small steps can help you significantly reduce the amount of college loan debt you’re carrying at graduation and could shorten the amount of time it will take you to repay those loans from a decade to seven years or less.

1) Make interest-only payments

Most student borrowers choose not to make any payments on their student loans while in school, which leads to the loans getting larger as interest charges accumulate and get tacked on to the original loan balance.

But you can easily prevent this “interest bloat” simply by making monthly interest-only payments, paying just enough to cover all the accrued interest charges each month.

The interest rate on unsubsidized federal undergraduate loans is low, fixed at just 6.8 percent. Even on a $10,000 loan, the interest that accumulates each month is just $56.67. By paying $57 a month while you’re in school, you’ll keep your loan balance from getting bigger than what you originally borrowed.

2) Make small, even tiny, payments on your principal

Beyond keeping your loan balances in check while you’re in school, you can actually reduce your debt load by paying a little bit more each month, so that you’re not just covering interest charges but also making payments toward your loan principal (the original loan balance).

Loan payments are typically applied first to any interest you owe and then to the principal. Payments that exceed the amount of accumulated interest will be used to reduce your principal balance. By paying down your principal balance while you’re still in school or in your grace period – even if it’s only by $10 or $15 a month -you’ll reduce the size of your college loan debt load by at least a few hundred dollars.

And by reducing your total debt amount, you’re also reducing the size of your monthly loan payment that’s going to be required once you leave school, as well as the amount of time it’s going to take you to repay the remaining loan balance.

3) Don’t ignore your private student loans

If you’re carrying any non-federal private student loans, use this prepayment strategy on those loans as well.

A few private education loan programs already require interest-only payments while you’re in school, but most private loans, like federal loans, allow you to defer making any payments until after graduation. As with federal loans, however, interest will continue to accrue.

Private student loans generally have less flexible repayment terms than federal loans and higher, variable interest rates, so your private loan balances may balloon much more quickly than your federal loans and can quickly spiral into the tens of thousands of dollars. Making interest-only or principal-and-interest payments will help you keep your private loan debt under control.

4) Look for non-loan sources of student aid

As you make your way through your second, third, and fourth years of college, if you find that your monthly student loan interest payments are creeping up beyond what you can comfortably pay, that may be a sign that you’re relying too much on college loans and your debt load is becoming more than you can manage.

Take steps to reduce borrowing by seeking out scholarships and grants, cutting down on living expenses, or finding part-time work.

As a student borrower, you should never lose track of how much you owe in school loans. By maintaining a continual connection to your student loan balances through monthly prepayments, you’ll have a better sense of where you stand financially throughout college and after you graduate.

A sound prepayment strategy will also help you establish good credit and plan for your financial future, knowing that your college loan balances are manageable and your school debt is under control.