Rabil and others in Barnard’s financial aid office certainly understood why private loans should be a last resort. But the school’s parents, even though many were college educated, didn’t appreciate the potential hazards of a private loan, which is the fastest growing source of student debt in the country.
Consequently, the school in New York City decided to educate its
moms and dads. When Barnard learns that a family is on the verge of
assuming a private loan, the school arranges a phone interview with
parents. After conversations with Barnard staffers, families often
abandon their plan to rely on a private loan. Thanks to Barnard’s initiative,
according to Inside Higher Ed, an online industry publication,
the volume of private loans at the school plummeted by 73%.
If you’re not sure why private loans should be a last resort, keep
reading. Here is what you need to know:
Private loans charge variable interest rates. Anyone with an
adjustable rate mortgage already knows why loans without ceiling caps
can be perilous. A loan with runaway payments can wreak havoc on a
student’s or parents’ budget. Many people don’t realize that private
loan payments, which might initially seem manageable, will change
because most private loans include variable interest rates that lack a ceiling cap.
Private lenders can discriminate. Unlike federal loan programs,
lenders that market private loans can pick and choose their
customers. Families with excellent credit can obtain better starting interest
rates than those with average or worse credit histories. The less
fortunate borrowers can get saddled with loans as bad as the subprime
mortgages that helped smash the housing bubble. The spread between
the starting interest rate for stellar customers versus those stuck
with the worst rate can be 10 percentage points or more.
What’s more, the interest rates and fees of private loans can vary
from school to school. Some lenders take into account a school’s overall
loan default rate. So even if you have a pristine credit history, you
could still get punished.
Private loans can be confusing. Many families who end up with
a private loan believe they have secured a federal loan. Sometimes
they don’t even realize the mistake they made until they try to consolidate
the debt with federal loans. There are many reasons for the confusion.
First, the loan process can be bewildering. And families, after
surviving the college matchmaking process, may hardly be in the
mood to sort through loan possibilities in the spring and summer leading
up to a child’s freshman year.
Parents and students just want the cash, and they figure they’ll
worry about how to pay it back later.
If you’re considering a private loan, here is what you should be doing:
Use federal loans first. Families should not consider private
loans, which are also called alternative loans, unless they have maxed
out the federal loans, which offer better terms and more flexible repayment
options. Federally guaranteed loans provide fixed rates, and
everybody—regardless of their FICO credit scores—receives the
same fixed interest rates.
The subsidized and unsubsidized federal Stafford loans are better
alternatives for student borrowers and the PLUS loan is best for
parents. If you meet the income qualifications, the federal Perkins
Loan is the cheapest.
Many families, however, are routinely snubbing federal assistance.
According to the Institute for Higher Education Policy, an astounding
20% of dependent students who have private loans never took advantage
of federal loans. Another 19% of borrowers never maxed out their
federal loans before embracing the private alternative.
Sadly, there are not enough schools like Barnard that are educating
parents about the perils of private loans. Some might assume that
Barnard can conduct its education effort because it’s small, but Colorado
State University has proven that even major institutions can
spread the word. At Colorado State, about 20% of applicants for private
loans either fail to exhaust their federal loan eligibility or skip filing
the FAFSA, which is a requirement for obtaining federal loans.
Staffers in the financial aid office at Colorado State call every family
that falls into one of these two categories and explain their options.
Cosign the loan. Because a borrower’s credit record is so important
for private loans, students are at a disadvantage when they apply
solo. With little or no history of using credit wisely, they can easily get
stiffed with mediocre loans that pass along higher interest rates and
fees. A parent who has good credit can avoid this problem by taking
out the loan themselves or by cosigning the loan. Most lenders will
consider only the highest credit scores among co-borrowers. What’s
more, the interest rate formulas for cosigned loans are slightly better
than those on noncosigned loans for the same credit score.
Don’t get tricked by slick marketers. If you’ve got a teenager
who will head off to college soon, lenders are probably stuffing your
mailbox with junk mail that makes obtaining a private loan seem as
easy as ordering Chinese takeout.
Here’s an excerpt from a letter sent by Sallie Mae, the big gorilla
in the student lending industry, that I received a couple of months before
my daughter began college: “Classes will start again before you
know it. Don’t let worrying about college expenses ruin your summer...
Applying is fast, free and easy. Borrow up to $40,000 a year.”
Sallie Mae went on to promise that my husband and I wouldn’t
have to worry about filling out any federal financial aid forms! Many
parents might think that is a plus, but the lender was recklessly
providing families with a way to jeopardize their chances for the
best financial aid. Parents should fill out the federal form—
FAFSA—because without doing so, they can’t obtain federal loans,
which are far preferable.
All the junk mail I received from lenders made private loans seem
like the best approach by offering, in the words of one lender, “fast”
credit decisions, “quick” renewals, and “easy” online applications. If
you haven’t been bombarded with these promotions, your child could
be getting inundated by Internet pop-up ads touting these loans.
The promises sound great, but the price you pay will be high.
Don’t be fooled by branded loans. When students receive
their financial aid packages, sometimes they will contain loans that
bear the name of the school. Beware of private loans masquerading as
school loans that are nothing more than marketing ploys. Students
may assume that the school branded loans are more favorable, but
these loans typically are just like any other private loan, and in some
cases they could be worse.
Ask intelligent questions. Before committing to a private loan,
ask these questions:
• Can I get a fixed-rate loan?
• If the interest rate is variable, is there a cap on how high it can go?
• What percentage of borrowers gets the best rate?
• Do you offer an interest rate discount or a reduction in principal
if I make on-time payments?
• Does the discount kick in when I start paying off my loan?
• If the discount isn’t immediate, how many months of on-time
payments must I make?
• If I miss a payment, is there anyway to recapture the discount?
• Are your discounts guaranteed or could they disappear later?
• If I encounter financial hardship, will you allow me to stop
payments temporarily without financially penalizing me?
• Is there a prepayment penalty?
• What index are your loans tied to?
Check your credit. If you’re contemplating applying for a private
loan, check your credit report. By federal law, you are entitled to a free
credit report annually from each of the three major credit bureaus:
Equifax (800) 685-1111, www.equifax.com
Experian (888) 397-3742, www.experian.com
TransUnion (800) 888-4213, www.transunion.com
If something is wrong, you’ll want to correct it.
Unfortunately, what the free reports can’t tell you is your credit
score. FICO, which is an abbreviation for its creator, Fair Isaac Corporation,
is the most common credit score. FICO scores range from
300 (abysmal) to 850 (phenomenal). Financial institutions generally
require minimum scores of 700 to 720 to qualify for the best loan interest
rates and terms. About 58% of Americans recently managed to
have a FICO score that was at least 700.
If your FICO score is less than 620 to 650, you will generally not
qualify for private student loans. Most lenders have five or six credit
tiers from 650 to 850 so a 30- to 40-point change in a credit score can
have a big impact on the cost of a loan.
If your credit score isn’t great, you should definitely try boosting
it. Taking this initiative could ultimately save you thousands of dollars
if you qualify for a more attractive private loan. You can discover many
ways to do just that by reading an excellent book, Your Credit Score:
How to Fix, Improve, and Protect the 3-Digit Number that Shapes
Your Financial Future, 2nd edition, by Liz Pulliam Weston.
Make timely payments. You never want to court trouble with a
lender whether it’s a private institution or the federal government.
One of the best ways to avoid punitive penalties for missing payments
is to sign up for automatic payments through your checking or savings
account. Many people mess up when they change residences and fail
to receive their bill. Don’t expect lenders to be sympathetic.
Action Plan
Never choose a private loan unless you have maxed out your federal loans.
Source: The College Solution: A Guide for Everyone Looking for the Right School at the Right Price
