Have Private Student Loans Become Smarter?


Deferred payment plans. Rock-bottom rates. Even loan balances wiped out for good behavior. These are all features of new loans designed to help college students and parents swallow the increasing costs of college but they may not be as generous as they sound.

Certainly, the new loans are compelling, with features that make paying back debt seem easier than ever. Sallie Mae will resurrect a loan that allows students to defer payments until after graduation, as opposed to paying while they're still in school, as they do now. For colleges that agree to replace grant programs with loans, National Education Servicing recently introduced a loan program that forgives 25% of the original balance for students who graduate and make every payment on time. But as appealing as they first appear, experts warn these loans may also feature rising rates, extra fees and longer repayment periods all of which add up to higher debt levels for students.

Students are already carrying the highest debt loads in history, and that number is growing. Students who signed up for private loans borrowed 14% more during the 2009-10 academic year, bringing the average to $8,584, according to the latest data from Sallie Mae. For the current school year, Wells Fargo says its total loan volume origination is up 20%. With colleges raising tuition costs, states cutting back on free aid to students, and colleges replacing grants with loans, these numbers may grow faster than in previous years, Mark Kantrowitz, founder of FinAid.org, which tracks financial aid trends.

Some of the new loans make it easier for schools to eliminate or cut back free aid. Wesley College, which has signed up with National Education, says it is replacing some grants with loans in financial aid packages for about 20% of incoming freshmen -- a decision that will forestall further cutbacks in its budget and existing grants, says Eric Nelson, vice president for finance at Wesley. So instead of grants, students could get a loan with a fixed interest rate of 6% that's deferred until graduation. Under the current terms, 10% of the loan amount is forgiven upon graduation, but the other 15% is only forgiven if every single payment is made on time. "Schools have told us that giving more free aid is an unsustainable model, and we're looking for ways to bridge the gap," says Matt Scotty, president of NES.

That's not the only grant program to cede ground to loans. This week Georgia's governor proposed funding a loan program in part for some stellar students who would otherwise receive the Hope scholarship, which currently covers tuition at in-state public colleges and up to $2,000 per semester at in-state private colleges. The loan, which could kick in as early as this fall, would offer up to $10,000 per year (for four years), a 1% fixed interest rate and a 10-year repayment period. "Some students will see a reduction in their grant amounts and those with unmet need could end up getting this loan," says Tracy Ireland, director of postsecondary student and school services at the Georgia Student Finance Commission. Over the past few years, the program, which is funded by the state's lottery, has paid out more money than it's brought in; last year the program ran a $150 million deficit, which could grow to $230 million this year.

Lenders are already clamoring for the business of student borrowers. They're responding to the growing demand, and also looking to replace the business they lost when Congress voted last spring to eliminate the Federal Family Education Loan program, which allowed private lenders to originate federal student loans that were guaranteed by the government. The number of lenders in the marketplace increased 27% in the past year, according to FinAid.org. And that doesn't include credit unions: Fynanz Inc., which originates and services private student loans for credit unions, says it is now working with around 100 credit unions, compared to about 50 a year ago.

Eventually, competition in the market may lower costs for students and families. Already some borrowers are paying lower interest rates. New last year, Wells Fargo's loan for adults who want to help pay for a child's college education has a variable interest rate starting at 3.5% -- compared to the federal PLUS loan with a fixed rate of 7.9%.

But for now, these new loans mostly represent higher costs across the board. First, they replace primarily free aid which automatically makes the final price tag more expensive. And many loans also come with origination fees of up to 10.5%, according to FinAid.org, -- around $900 on the average loan -- and it's often rolled into the loan. Other students will find themselves paying more just to apply for a loan (application fees at NES are $75), a charge of up to 3% when the loan enters repayment, and up to $50 per quarter while in forbearance. And though Sallie Mae declined to discuss the specifics of its new program on the record, loans that allow for deferred payment leave borrowers deeper in debt than those that require immediate payments. Eventually you have to pay back the principal, plus several years of accrued interest making college even more expensive.

A New Student Loan Based on Future Salary

The whole point of going into debt to go to college is to get a better career one that will ultimately allow students to afford their loan payments. Now, Enzi, Silicon Valley start-up, has an novel idea: Letting students stake their future income against loans for tuition, room and board.

Here's how it works: Enzi will pay for tuition, room and board, if a student commits to monthly payments of 7.5% to 15.5% of their gross annual income for nine to 13 years after graduation. There is no interest rate, no payments are made during college enrollment, and repayment begins three months after graduation if a student hasn't landed a job, he can defer payments.

Is it a good deal? That depends. The repayment terms are based on several factors, including the student's major, grades, intended career, and the college he attends. So far, Enzi has only tested the program on graduate engineering students at Stanford, and plans to roll it out for graduate engineering students at the University of California, Berkeley, this fall.

For purposes of illustration, Enzi assumes a starting salary of $85,000 per year. At an 11.5% repayment rate for 11 years (not assuming any raises), the student would end up paying $107,525 -- about 1.5 times the average cost of an Masters of Science in Mechanical Engineering at Stanford.