JULY 3, 2010.Student Loans Get a Makeover .ArticleCommentsmore in Personal Finance By JANE J. KIM
Families shopping for student loans to help pay for college this fall could find it easier to get a federal loan—and will probably pay less, too—as new laws relegate private lenders to a smaller role. But securing a private loan could require more legwork.

The changes, part of a health-care overhaul that was signed into law this spring, cut out the private-sector middlemen from offering federal loans as of July 1, while boosting federal grant programs. The new rules should help eliminate some of the confusion between private and federal loans, since many banks had offered both.

Private lenders, for their part, have been scrambling to redefine themselves, either as service providers or private student-loan companies. Some, such as Bank of America Corp., have stopped offering new loans.

In the short term, the changes are spurring competition, potentially leading to better terms for some borrowers. On Thursday, Wells Fargo & Co. dropped rates across the board on two of its private student loans, including a loan for parents that it launched in May—even as J.P. Morgan Chase & Co. raised rates on its private loans. In recent months, SLM Corp.’s Sallie Mae, Citigroup Inc.’s Student Loan Corp., Royal Bank of Scotland Group PLC’s Citizens Bank, and SunTrust Banks Inc. have dropped rates on their private loans.

The changes come at a time when more students are borrowing to keep up with rising tuition costs and declining state support. About two-thirds of 2008 graduates from four-year colleges had student debt, and that debt averaged $23,200, up from $18,650 in 2004, according to the Institute for College Access and Success, a nonprofit based in Oakland, Calif., that runs the Project on Student Debt.

Debt loads have grown large enough to influence many students’ choice of schools and careers. When Caroline Andero was an undergraduate at Baylor University in Waco, Texas, from 2004 to 2008, she ended up taking out about $76,000 in private student loans. That amount later ballooned to over $100,000, including capitalized interest.

Ms. Andero says that her undergraduate loans were a big factor in her decision to attend the University of Mississippi’s law school over other highly ranked schools, as the school gave her a better financial-aid package. She says she turned to private loans to help cover “the extra stuff, like room and board and living expenses and traveling back and forth. We weren’t aware of the benefits of federal loans.”

Schools today are more likely to steer students to federal options first, says Ms. Andero, who lives in Meridian, Miss. “When I came to law school, the financial-aid office really drilled it in that you needed to do federal loans first,” she says. As a result, she has taken out only federal loans to pay for law school.

If you are planning to apply for a student loan this summer, here are some pointers to keep in mind.

Maximizing Federal Loans
Aim to maximize federal loans first. Unlike private student loans—with rates that are variable and will surge higher once interest rates rise—rates on federal loans are fixed. And under legislation enacted in 2007, the rates on new subsidized Stafford loans for undergraduate students, which are available for borrowers who demonstrate economic need, will drop to 4.5% for the academic year 2010-11 from 5.6% last year. Unsubsidized Stafford loans, which aren’t need-based, and subsidized Stafford loans for graduate students carry a fixed rate of 6.8%.

Federal loans also offer more-flexible repayment options than private student loans. If you are experiencing economic hardship, for example, you can apply to suspend repayment for up to three years, or have your monthly payments reset to a percentage of your discretionary income, not the amount you owe. Some borrowers who are on income-based repayment plans and who work full-time in public-service jobs for at least 10 years also can qualify to have the balance of their federal loans forgiven.

But because of the limits on Stafford loans, parents may turn to a federal Parent Loan for Undergraduate Students to make up any tuition shortfall. Under the U.S. Department of Education’s Direct Loan Program, PLUS loans carry a fixed rate of 7.9%, compared with the 8.5% rate offered by most private lenders.

More parents are likely to qualify for PLUS loans since the approval rates are higher under the Direct Loan Program than they have been at private lenders, some say. (Graduate and professional students also can borrow money through the PLUS program to pay for their own education.)

Deals on Private Loans
Even though private lenders won’t be originating any new federal loans, some will still be servicing them—as well as looking to make more private ones. In May, for example, Sallie Mae cut rates on its Smart Option Student Loan—which, unlike other private student loans, requires students to make interest payments in school—by a couple of percentage points. This past week, the lender began offering a $25-a-month repayment option for borrowers.

More credit unions also are jumping into the business. Since May 2008, some 150 credit unions have joined the Credit Union Student Choice program, a group that helps credit unions offer nonfederal student loans, with an average rate on existing loans of 6.25% with zero origination fees. Earlier this year, Pentagon Federal Credit Union of Alexandria, Va., launched a private student loan, now offering a variable rate of 5.5% in school with no origination fees. (It turns into a 15-year fixed rate in the repayment period.)

Still, while many lenders are lowering their rates, borrowers need stellar credit to qualify for the best deals, says Tim Ranzetta, president of Student Lending Analytics, a research firm in Palo Alto, Calif.

Meanwhile, the financial-regulation bill currently in Congress calls for the formation of a Consumer Financial Protection Bureau that will have oversight over private student loans and other financial products and give borrowers more protections. One of the provisions, for example, could set up a private student-loan ombudsman—similar to one that already exists for federal loans—to whom borrowers with grievances can turn.

That should help students like Ms. Andero, the law student, who are struggling with rising debt loads. “I feel like the loans are dictating what I need to do when I graduate,” says the 24-year-old, who expects she will leave school with about $160,000 in private and federal loans. “If debt weren’t an issue, I wouldn’t even be here in law school. I would maybe be in a third-world country doing community-development work.”