Q: "It looks like we're going to need to take out a private student loan to help pay for our son's education. How do we find a reputable bank that's going to give us a good deal?" — Steve, Canton, Ohio
A: Needing a private student loan is often a sign of overborrowing, since the federal loan limits are usually sufficient. If your son's total education debt at graduation exceeds his starting salary, he'll have difficulty repaying his loans and will need to use an alternate repayment plan — such as extended repayment or income-based repayment — to afford the monthly payments. Even worse, these repayment plans reduce the monthly payment by stretching out the term of the loan, which can ultimately increase the loan's cost.
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You should always borrow federal first, as the federal education loans are cheaper, more available and have better repayment terms than private student loans. The interest rates on federal education loans are fixed and won't increase over the next few years when interest rates on variable-rate loans start returning to historic norms.
To get a sense of what the federal loans have to offer, let's take a look at the Stafford and Parent PLUS loans.
The federal Stafford loan has an annual loan limit that ranges from $7,500 to $9,500 for dependent students, allowing them to borrow up to $35,000 over the first four years. The federal Parent PLUS loan, on the other hand, lets parents borrow up to the full cost of education minus the other aid received. With both the Stafford and PLUS loans in place, really there should be no need to borrow a private student loan.
But let's say you are ineligible for the Parent PLUS loan. Your son would then become eligible for the higher unsubsidized Stafford loan limits available to independent students, and these annual loans limits range from $9,500 to $12,500, for a total debt of up to $45,000 during the first four years.
But if you are ineligible for the federal PLUS loan, then you are extremely unlikely to qualify as a borrower or cosigner on a private student loan, period. Credit underwriting criteria for private student loans are much harsher than the eligibility restrictions on federal education loans. And your son will be unable to obtain a private student loan on his own without a cosigner, since most private student loans these days require one.
Even if your son could qualify for a private student loan on his own, it's still a better idea to apply with a cosigner. With two fish on the hook instead of just one, often this means a slightly better interest rate. Also, most lenders base the eligibility, interest rates and fees on the higher of the two credit scores, so applying with a creditworthy cosigner can save the borrower money by helping him obtain a lower cost loan.
Remember, a cosigner is really a co-borrower. The cosigner is just as obligated to repay the debt as the primary borrower. So if the borrower is late with the monthly payments, the delinquency will ruin both the borrower and cosigner's credit scores. Think twice before agreeing to cosign a private student loan.
Another thing to keep in mind when shopping for student loans is that few lenders of private student loans offer up-front pricing. The only way to discover the actual interest rate is to apply, which means you'll need to shop around, and literally apply, for several private student loans. Several student loan comparison sites let you compare pricing on many private student loans simultaneously, but often most have information about only a half dozen or so lenders (some have just one), and some will present the best advertised rate or the average interest rate. Compare the loans based on the actual interest rates you will receive. And beware of teaser rates, which often do not last and are available only to borrowers with an excellent credit score. Most borrowers will be stuck with much higher interest rates.
When comparing interest rates, do it on an apples-to-apples basis. Comparing two loans with different loan terms isn't realistic. For example, increasing the loan term on an unsubsidized Stafford loan from 10 years to 20 years cuts the monthly payment by about a third but more than doubles the total interest paid over the life of the loan.
The good news is the new Truth in Lending Act regulations require lenders to provide borrowers with several key pieces of information with a loan: the interest rate and fees, the loan term in years, the monthly payment and the total of all payments. This makes it easier to compare different loans.
It also helps to understand how lenders assign you your interest rate. Most lenders have a half dozen credit score tiers, and each tier corresponds to a single interest rate and fee. A 50 to 100 point change in your credit scores may be sufficient to move you from one tier to the next.
Don't forget to factor the fees into the cost of the loan as well. Every 4% in fees is equivalent to increasing the interest rate by about 1%.
Most private student loans have variable interest rates that are pegged to a variable rate index like the LIBOR index or the Prime Lending Rate. For example, an interest rate of the one-month LIBOR index plus 6% is equal to 6.25% when the LIBOR index is equal to 0.25% and is equal to 12.25% when the LIBOR index is 6%. All else being equal, pick a loan with an interest rate that is pegged to the LIBOR index, as the LIBOR index increases more slowly than the Prime Lending Rate.
Other borrowing options include borrowing using home equity, credit cards, a personal loan from your hometown bank and peer-to-peer education loans.
Home equity loans and lines of credit put your home at risk if you default on the debt. But if you default on a student loan, the lender cannot repossess your education.
Using credit cards is generally a bad idea because of the high interest rates, unless you need to charge a small amount of money to the card for a short-term emergency, such as when the college is withholding your diploma until you pay a parking ticket or library fine. That said, credit card debt can be discharged in bankruptcy while student loans currently cannot except in rare circumstances.
Peer-to-peer education loans are relatively new loans where friends and family, or even strangers, provide you with a personal loan. Unfortunately, peer-to-peer education lending is in its infancy, and less than one in ten borrowers receives a loan, often for less than the amount requested.
—Mark Kantrowitz is president of MK Consulting Inc. and publisher of the FinAid.org and FastWeb.com. He has testified before Congress about student aid on several occasions and is on the editorial board of the Council on Law in Higher Education.