Safeguards Needed for Private Student Loans

As much as we'd like not to have to admit it, we have entered a new era -- in which private student loans are becoming an essential financing tool for undergraduate students.

This might not be so worrisome if these loans were going only to upper middle class and affluent students. But that's not the case. According to a report last year by the Institute for Higher Education Policy nearly 30 percent of dependent students who borrow private loans come from families making under $40,000 a year and about 1 in 10 come from families earning less than $20,000 annually. This should be of major concern to educators and public policy makers alike.

Given this trend, we believe that there are two essential safeguards that should be in place to protect these borrowers. First, before offering private loans to student-loan borrowers, colleges and lenders must ensure that students have first had to exhaust their federal student loan eligibility. Federal loans are a much better deal for students than private loans, and offer important protections than private loan providers aren't able to provide. We can't think of a single case in which a student is better off receiving a private loan than a federal loan.

Second, and even more importantly, we need to make sure that students are fully informed about the terms and conditions of these loans before they take them out. Colleges and lenders alike have a sacred responsibility to make sure they have obtained the informed consent of borrowers -- because for students, not knowing what they are getting into can cause them a lifetime of problems.

Unfortunately, we are not meeting these two conditions today. A substantial proportion of financially-needy students are taking out private loans before exhausting their federal student loan eligibility. According to the Institute for Higher Education Policy, 20 percent of dependent students with private loans had not taken out federal loans at all, and an additional 19 percent had federal loans but had not borrowed up to the federal limits.

And many students and their parents are reporting that they didn't understand what they were getting themselves into when they took out the loans. They didnt realize, for example, that the interest rate on their loans wasnt capped, or that their monthly payments would continuously grow, or that the Sallie Mae loan they took out wasn't a federal one.

When they hear those stories, loan industry officials often say that students and their families just have to take more responsibility for their actions. "Grow up," they say. "You're adults now and you need to do your homework before taking out loans."

Now there may be some truth to those statements, but only if students and their families are being fully informed about all of their options. Otherwise the lenders are trying to have it both ways -- misleading students into taking high cost loans, and then blaming them for making bad and potentially life-altering choices.

FRIGHTENING TRENDS

There are two alarming trends that have contributed to the confusion borrowers are facing.

The first trend has been the enormous growth in direct-to-consumer marketing of private loans. Borrowers are being inundated with pop-up ads on the Internet offering them with easy to obtain loans of $30,000, $40,000, and even $50,000 a year. Imagine leaving college with $200,000 in loans. Kiss any chance of going to graduate school, or entering a public-service profession goodbye.

Even we were surprised when watching ESPN recently to see a broadcast advertisement for Astrive Student Loans, a private-loan product from Citizens Financial Group. "Get $30,000 for college a year," the ad said, "and you won't even have to make your first payment until 6 months after you graduate." Sounded pretty good, having all that time to wait before having to start paying the loan back -- except that it's the same grace period that federal student loans offer and those loans are a lot cheaper. As far as we remember, the ad didn't mention that unlike the case with federally-subsidized loans -- interest on Astrive loans would accrue while you're in college.

So far thats the only television ad we've seen for a private loan product -- but we suspect its not the only one out there, and that it's just the beginning of a trend. A frightening trend.

It might not be so bad if some direct-to-consumer private student loan providers were not actively discouraging students from taking out federal loans. Companies like Educap's Loan to Learn will deny until they are blue in the face that they are doing this, but when you read statements in their marketing materials that stress just how complex it is to obtain a federal loan, you have to wonder whether they really believe what they are saying.

PACKAGING PRIVATE LOANS

As much as we'd like to, we can't put all the blame, however, on direct to consumer marketers. There is another equally worrisome --potentially even more worrisome -- trend occurring in which colleges are putting students in harm's way -- and that is the inclusion of private student loans in student aid packages. According to a survey unveiled at NASFAA's conference, more than 100 colleges -- or nearly 8 percent of institutions that participated in the survey -- are including private loans in the financial aid packages they offer students. This practice gives students the misleading impression that they are obligated to take out these loans. It also gives them the impression that these loans have the colleges' imprimatur -- and therefore must have pretty reasonable terms, which they often do not.

Worse, some lenders are encouraging colleges to brand the loans with their institutions names -- which only adds to the confusion. Last year, The Chronicle of Higher Education profiled a student who -- as part of his financial aid package -- took out an "American University Educational Loan." The student's mother, who helped sign off on the loan, had assumed that the loans were being made by the college, and therefore, had terms at least as generous as those the government offers.

What she hadn't realized was that they were private loans offered through First Marbleheads GATE program -- and that the interest rate on these loans would not only be uncapped, but would rise month to month depending on shifts in the prime rate. When her son first took out the loan, it had an attractive interest rate of 5.9 percent. But by the time, he began to repay it, that rate had shot up to 9 percent.

This mother was embittered. She said that colleges should go out of their way to make sure that students and their parents "truly make informed decisions" about taking out private loans.

It seems to us that we would all be better off -- students, parents, and colleges, which rely on the goodwill of their alumni -- if we followed her advice.

Editor's Note: This blog post is based on comments delivered by Stephen Burd at this week's annual conference of the National Associations of Student Financial Aid Administrators (NASFAA).