Sunday, August 17, 2008

School Loans: Private vs. Federal

I was reading the latest issue of BusinessWeek the other day (for all you Office fans, Dwight Schrute was on the cover!), and I came across an article called "Getting Smarter on School Loans."

Now, we've heard it all before: faster, easier "tricks" to paying off student loans. I, too, am guilty; even I recently wrote about it. But what caught my eye about this approach was that the article analyzed the type of loan being considered, versus how to pay it off after the fact ... bringing us to the ultimate crossroads: private student loans versus federal ones.

Many of you might think this one is a no-brainer -- of course, federal student loans would make more sense, right? Yes, but you wouldn't know it delving into the recent credit habits of the college bound and/or their educationally encouraging parents. According to the recent BusinessWeek survey quoted, college students and the like have fallen back on a thick padding of credit cards, home equity and private loans to pay for school. So what's the big deal, you ask?

First off, this is exactly the kind of thinking (or spending, if you will) that got us into the credit crunch and subprime mess we're currently in. In fact, earlier this month Wachovia joined a list of more than 150 other banks who do not offer student loans anymore, according to the article. It may seem like private student loans may also, like the antiquated times of the Old South pre-Civil War, be gone with the wind. The good news is this might be one of the best things to happen to many students and parents who need financial ushering when it comes to making the best decisions.
"In a weird way, the credit crunch may be an important wake-up call for some families who had been financing tuition costs in irrational and expensive ways during the era of easy money and rapidly rising home prices. The growing skittishness of lenders force more borrowers to exhaust their federal options, a growing pool of funds that typically have lower interest rates and more favorable terms."
Or so the article states. Don't believe it? Just take a look at the numbers (courtesy of the magazine):
  • Fixed rates on federal student loans usually fall between 6.8% to 8%, versus adjustable private loan rates of between 8% to 20%. (For comparison purposes, the average interest rate on a credit card is 13%.)
With numbers (generally) that disparate, some may wonder why there's even a comparison. But although the choice might be obvious to many, the story states that convenience plays a bigger factor in finding a loan or amassing debt versus saving by finding the cheapest interest rate. BusinessWeek dubs this phenomenon "The Cost of Convenience."

Even though 77% of students and 36% of parents sign up with federal student loans, both parties tend to fall back on other sources to "supplement" that money, says an impending Sallie Mae survey, which also points out that:
  • 19% of parents who borrowed federal money for student loans ended up charging tuition on a credit card.
  • 20% of parents who signed up for federal loans used home-equity loans to pay down tuition (an average $10,854).
  • More than 25% of students who used credit cards "did so out of convenience."
According to education firm College Board, private loans have grown 27% each year between 2001 and 2007, versus 7% per year for federal loans. Why the huge disparity? Simple! It all comes down to that cunning little thing called "convenience."

Private lenders usually make the sign up process extraordinarily easy for those with their palms out. In many cases, the article says, consumers only need to a phone call or fill out a basic online form to gain access to tons of money (and, unfortunately, interest-laden debt). In some cases, financial aid officers were herding confused parents to the offices of private loan firms. The whole matter was investigated by the N.Y. Attorney General in 2007, who found that aid officers at certain large universities were receiving "kickbacks" from private lenders, who reaped the benefits of getting clueless students and parents to sign up with them.

Now compare the simple private-loan process to the complicated federal one, which consists of the FAFSA, an over 100-question long survey that includes uber-private questions about family earnings and financial history. Couple that with the stacks of tax and other financial documentation needed to supplement the FAFSA, and you can see why any stressed out college student or parents of a college student would rather take the easy way out. According to the Sallie Mae poll in BusinessWeek, 25% of people borrowing money didn't even bother filling out the FAFSA.

The good news is that with private lenders retreating, Congress has recently expanded the limits on Stafford loans (the primary type of government school loan that's available regardless of family income or credit history). Students now get an extra $2,000 per year with the Stafford.

And there may still be light at the end of the tunnel in that some colleges, such as Barnard, now require families to speak to a financial aid counselor before enrollment in the school is certified -- which is needed before you can even sign up for a student loan. Since Barnard's program has started, say the article, its volume of private loans has dropped to $435,000 from $1.5 million.

Barnard's director of financial aid characterized private loans perfectly: "[They] are like well priced credit card[s]."

So what does this all mean to you? Whatever phase of life you're in (i.e., with or without kids, looking into going back to school, about to graduate high school,etc.), it's always important to know exactly what you're getting into when you sign your John Hancock to the bottom of that loan contract. Exhaust all of your options and make sure your decision is right for you, and not just right for the guy trying to sell it to you. After all, the backbone of your life is your money, and the decisions you make with it can determine your lifestyle for years to come!

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