The intersection of technology, research, financial aid and student access in higher education

A Two-Tiered System of Student Loans ♦

Added on by Scott Cline.

This week the San Francsico Chronicle published their, it seems, yearly article on the dangers of private loans.

Facts You Didn't Know About Private Student Loans

In most cases, private student loans aren't your best option, so make sure you know exactly what you're signing up for. Research each loan before you accept the terms. Your loan could be with you for a very long time, so don't jump into anything without knowing exactly how much it's going to cost and for how long.

They caught all of the usual reasons why private student loans are more dangerous then federal student loans. This article was written for parents and students. What this article missed is the changing environment of private loans. It was at one point that private loans were the last resort for students who needed more funds then federal loans could provide. Often these were students who the Department of Education still considered dependent of their parents, but the parents could not or would not provide support. The parents would not apply for Parent PLUS loan and the student did not qualify for higher loan limits granted independent students. These student would often not have high credit scores (or co-signers with high credit scores) and would thus be offered high variable interest rates on private loans.

A few things have changed--a recession, an environment of low interest rates for people with outstanding credit, the exclusion of the private lenders from federal loans, and finally, the option of fix-rate private loans. Student loan lenders tightened credit requirements and stopped even offering credit to even marginally risky borrowers.

The environment for the past two academic years is one where if a student (or in some cases a parent) with a co-signer with an excellent credit rating could take out a private student loan with a 2.5% to 3.5% APR. Often these loans had zero origination fees. The interest rate was still variable. The variable interest rate, I believe, still scared many families coming out of the variable interest rate mortgage collapse, but I think that is already starting to fade into the background. Federal Direct Unsubsidized loans have fixed interest rates at 6.8% with a 1% origination fee and Direct Parent PLUS loans (the loans that are offered to parents of dependent undergraduate students) have fixed interest rates at 7.9% with a 4% origination fee. Student and their well-qualified credit parents seem to be really weighing these comparisons now.

Add to this, the introduction of private fixed-rate loans from many of the major players in private student loans. These loans (again for well-qualified students and their co-signers) often complete with Direct Unsubsidized loans and beat the Parent PLUS loans.

I believe this is going to be the year to watch for this shift and see how many well-qualified credit students and their families forgo their federal (Unsubsidized and PLUS) loans in place of a private loan. Non-well-qualified credit students and their families will still be stuck with the higher interest rate "safe" federal loans.

What would happen to the federal loan program over a few years if the well-qualified credit students and their families exited the federal loan programs while at the same time the lower-income students and their families remain in the program? What would happen to school default rates for those federal loan programs? Student loan defaults are a trailing indicator because they take years, if not a decade, to play out.

While I do see this playing out, I worry what this will mean for college access if we have a two tiered student loan program.