Federal student loans offer a less costly alternative

Posted at 06:19 PM on Saturday, Oct. 24, 2009

I can't stand debt. One of my missions in life is to help keep people out of debt.

So I take it as good news that private student loans are declining fast. According to a new report from the College Board, the amount of nonfederal education loans in 2008-09 dropped by almost 50% from the previous year, and fell to 13% of the market from 25% a year earlier.

SLM Corp., commonly known as Sallie Mae, recently reported a significant drop in its private lending. In it's third-quarter report, Sallie Mae, the nation's largest student loan lender, said it had originated $893 million in private education loans, a decrease from $2.1 billion for the same quarter a year ago.

The reason for this trend is obvious. The terrible recession has broken a long-standing trend toward private loans, which generally carry higher interest rates than federally subsidized or unsubsidized loans.

Additionally, borrowers don't get the same protections or perks.

For example, the government pays the interest on subsidized Stafford Loans and Perkins Loans while a student is in school.

Subsidized Stafford loans are awarded to students who have demonstrated financial need. Unsubsidized loans are awarded regardless of financial need and students are responsible for the interest, although they don't have to make payments while in school.

Clearly, of the two types of loans, subsidized is better because with an unsubsidized loan, unpaid interest that accrued during the in-school period and the six-month grace period after leaving school is added to the loan principal.

"Students should always borrow federal first, as federal loans are cheaper," said Mark Kantrowitz, publisher of FinAid.org and FastWeb.com.

The interest rate on federally subsidized Stafford loans was 6% in 2008-09. The rate dropped to 5.6% in 2009-10, and is scheduled to decline to 3.4% in 2011-12. The interest rate on unsubsidized Stafford loans is fixed at 6.8%.

Kantrowitz also points out that federal loans have better consumer protections, such as economic hardship deferment, greater availability of forbearances, and flexible repayment programs.

Interest rates for private student loans currently range from about 9.5% to 10%, down about one percentage point from the previous year, says Tim Ranzetta president of Student Lending Analytics, a California-based company that provides research and advisory services to college financial aid officers.

And these rates aren't fixed.

"People should expect their private student loan rates to move up as the economy strengthens," he said, adding that these borrowers typically see a three- or four-point interest-rate increase from their starting point.

Still, about 15% of undergraduate students borrowed from private lending sources in 2007-08.

It's no surprise that federal lending is growing and in 2008-09 accounted for 45% of the $125.7 billion in financial aid received by undergraduates, an increase of $14.7 billion from the previous year, according to the College Board.

Last year, Congress passed legislation raising the annual limit for unsubsidized Stafford loans by an additional $2,000 each year. The total federal loan limits (unsubsidized and subsidized) increased from $23,000 to $31,000 for dependent undergraduates, and from $46,000 to $57,500 for independent undergraduates.

The decrease in private lending can be attributed to these larger federal lending limits, tougher private lending standards, more student loan defaults and the inability of lenders to sell loans in a secondary market.

Is shifting borrowing from private student loans to federal good for students and their parents?

It certainly got a lot of thumbs up.

"Absolutely, it's great that private loan borrowing is down, but with one caveat," Ranzetta said. "Is this going to lead to overborrowing with federal loans?"

No doubt it will.

"We are very concerned some students are borrowing much too much," said Sandy Baum, senior policy analyst at the College Board and former professor of economics at Skidmore College.

But Baum was quick to point out that the percentage of students borrowing incredibly high levels of debt is still relatively low.

Sixty-five percent of 2007-08 bachelor's degree recipients graduated with education debt, and the median debt for those who borrowed was $20,000, the College Board reported.

About 6% of students at public schools had borrowed $40,000 or more. That percentage jumps to 24% for private schools.

Whether it's high-priced debt or lower-cost federal debt, it's still too much for too many students and their parents.