The Best Rates on Private Loans

LIKE BEER PONG AND illegal music swapping, student loans have become an unavoidable part of the college experience.

Graduate students paid more than three quarters (76%) of their 2004-05 school bills using student loans, according to the College Board, a nonprofit organization for education testing and information. And nearly half (46%) of undergraduates' costs were covered by loans. With both graduate and undergraduate students, the proportion of loans compared to grants and other forms of financial aid is growing.

So if you've got college-bound kids, chances are you or your children will have to take on debt to pay the college bills. And while shopping for the federally guaranteed Stafford and Perkins loans is relatively straightforward — the financial aid office basically sets the limit on how much you can borrow and the government determines the interest rates — shopping for a private education loan is an entirely different thing.

Why? Because private lenders are free to set the loan terms — including the fees and interest rates — as they wish, and then don't have to disclose these terms until you send in your application. "It's hard to compare apples to apples before you actually apply," says Mark Kantrowitz, publisher of FinAid.org, an online financial aid resource.

At the same time, private loans — which are typically used for covering a student's unmet need, or that part of the bill that isn't covered by financial aid — are becoming harder to avoid. (PLUS loans, which are federally guaranteed loans designed for students' parents and will be available to graduate students starting this academic year, are another way to bridge the need gap; we'll discuss more below.)

"As tuition costs have continued to rise and federal loans have not kept pace, we've seen an increase in private education loans," says Martha Holler, spokeswoman for education lender Sallie Mae. In 2004-05, 18% of all educational loan volume was private loans, according to the College Board, compared with only 8.8% four years earlier.

Below is a guide to uncovering the secrets of private education loans — and how to get the best deal.

The Basics

Like their federally-guaranteed cousins, private education loans can be used for college expenses, including tuition and fees, room and board. And while interest does accrue while you're in school — as is the case with unsubsidized Stafford loans — no payments are typically due until six months after graduation.

Unlike federal loans, the terms of private loans are set by the individual lenders. Rates are tied either to the prime rate (currently at 8%), or to the three-month LIBOR (the rate international banks charge each other for loans, currently at 5.4%).

But because the company runs a credit check when you apply, the rates advertised by lenders aren't necessarily the ones you'll get. Your interest rate is determined by your credit history, your debt-to-income ratio and, with many lenders, by the school you will be attending. (Someone attending Harvard will likely get a lower interest rate than someone attending XYZ College if Harvard's default rate is lower than that of XYZ, according to Mike Reardon, chairman of Citibank's Student Loan Corporation.)

These days, the best student loan offers have rates of LIBOR + 2.8% or prime + 0% (8.2% or 8%, respectively), according to FinAid.org's Kantrowitz. But these rates are reserved for the best applicants, he explains. The worse your credit history, the more will be tacked onto the prime rate or the LIBOR, so even though a lender may be advertising loans at 8%, you may be offered 10% or higher. If your credit score is lower than 650, chances are you will not qualify for a loan at all. The same goes for fees, which are also based on the applicant's credit and in some cases, the amount of the loan.

The catch: The lenders won't tell you what interest rate or fees you'll get unless you actually apply. This makes shopping around trickier, as each application with a lender affects your credit score — and in turn may result in getting lower rate offers by consecutive lenders.

The FICO score treats student loan inquiries the same way it treats credit card inquiries, according to Barry Paperno, manager of consumer operations at Fair Isaac, the company that calculates credit scores. In contrast with mortgage or car-loan applications, borrowers get a 30-day buffer, which means the inquiry will not appear in their credit report within 30 days of applying — thus allowing consumers to shop around for the best rate for at least one month. Additionally, auto- or mortgage-loan inquiries made within 45 days of each other are treated by FICO as just one inquiry, allowing you to apply with a large number of lenders without dragging down your score for each consecutive lender. But that's not the case with private student loans. New credit applications have a negative effect on your credit score because lenders view the fact that you're looking for more credit as a risk.

And if that weren't enough, the rate you qualify for while in school may not be what you'll pay once you enter repayment. "Once you graduate, the rate may jump by one or two percentage points," Kantrowitz says. This, however, should be outlined in the paperwork you sign to complete the loan process. Bottom line: Before deciding on a lender, always ask how the rate formula changes in repayment and if there will be any additional fees.

How to find the best deal

There's not much you can do about the interest rates you qualify for, but there are other ways to compare lenders. Here's how to shop around.

Start with your financial-aid office

Your school's financial-aid office should have a list of preferred lenders. Additionally, some lenders may agree to offer a school a pool of money to lend out at preferred terms — without checking students' credit history, for example — in exchange for being on a university's preferred lenders list, Kantrowitz explains. (If you're interested in what the lenders that aren't on your school's list have to offer, FinAid.org's section on Private Student Loans keeps a list of private loan offers updated before the start of each school year.

Ask about interest capitalization

This is basically how often the amount of accrued interest is added to your loan principal. Some lenders capitalize your interest annually, others do it once a quarter, and some capitalize interest only once you enter repayment. "It can have a big impact on the cost of the loan," Kantrowitz says. The more frequently interest is capitalized, the more you end up paying because you are basically paying interest on interest as it compounds.

Research borrower benefits

Some lenders offer interest rate reductions or principal refunds if you pay your loan on time. With Citibank's private loans, you will receive a 0.25% rate reduction when you sign up for automatic payment withdrawals from your bank account and another 0.50% reduction after you make 48 consecutive on-time monthly payments. Wells Fargo clients can reduce their rate by as much as one percentage point if they select automatic withdrawals and make 48 timely payments. Sallie Mae, on the other hand, offers no borrower benefits for its private loans. All three banks advertise prime + 0% for their best-qualified applicants.

Use a co-signer

Because your debt-to-income ratio is part of the formula banks use to determine your loan rate, students may want to ask a parent to co-sign the loan so they can qualify for better terms. (That's in the event that the student has no income, of course, a common situation among undergrads. In addition to that, a co-signer with poor credit may not be of much help.)

Just be warned: Once a parent co-signs that loan, they are on the hook should the student fail to repay it. Some lenders offer the so-called "co-signer release" benefit to good customers that allows the co-signer to be taken off the loan after a number of on-time payments. At Wells Fargo, for example, your co-signer is off the hook after you make your first 24 consecutive payments on time.

Consider a PLUS loan

PLUS loans are federally guaranteed loans available to parents. Their big advantage: The rate is a fixed 8.5% until 2012, thanks to legislation Congress passed earlier this year. (It used to be that rates on PLUS and Stafford loans were reset annually.) While that's currently 50 basis points below the best rates offered on private education loans, remember that private loan rates are variable and should interest rates continue heading upwards, so will private loan rates.

The only drawback of PLUS loans: Repayment starts immediately, while private loan payments can be deferred while the student is in school.

Graduate students: Now you can take a PLUS loan too

The big news for graduate students: Starting this year, you can take out PLUS loans as well. This means you can forego taking out private loans entirely, since PLUS loans carry no borrowing limits. (Students can borrow up to the cost of attendance minus aid received.) An added benefit: Unlike PLUS loans for parents, where payments start immediately after taking the loan, graduate students can defer PLUS repayment while in school.

• • Getting Started
• • 10 Things College Financial Offices Won’t Tell You
• • Comparing Financial Aid Offers