When the new Consumer Financial Protection Bureau starts its work on private student loans in earnest, it will have to confront a question that has vexed policymakers and student aid experts in recent years: Why do so many students take on this debt without exhausting their eligibility for federal loans first?
According to the most recent data available from the Department of Education, the majority of undergraduates who borrowed private loans in the academic year 2007-08 did so even though they hadn’t taken out all of the federal loan debt for which they were qualified. Nearly one quarter of these private loan borrowers did not take out any federal loans at all.
This is a major public policy problem because private loans are far more risky than federal loans and almost always much more expensive. Unlike federal loans, which carry a fixed rate, private loans generally have uncapped interest rates that vary month to month based on market conditions. While federal loans offer the same terms to all borrowers, private loan providers tend to charge higher rates to those with the greatest need.
Federal loans also offer much greater consumer protections than private loans. Borrowers in the federal programs who become unemployed or suffer economic hardship, for instance, have a legal right to have their loans deferred for several years. Private loan borrowers who run into trouble don't have that option. And unlike federal loans, private loans are not automatically discharged if a borrower dies, is permanently disabled, or attends a school that unexpectedly shuts down before that student completes his or her studies.
In fact, one of the only similarities between these two types of student debt is that neither generally can be discharged in bankruptcy.
So why are such large numbers of students acting against their own self interest? Our friends at the Project on Student Debt recently posed that question to nearly two dozen financial aid directors from a wide variety of institutions. [Editor’s Note: Higher Ed Watch is supported in part by a grant from the Institute for College Access and Success, which runs the Project on Student Debt.] According to the project’s new report “Critical Choices: How Colleges Can Help Students and Families Make Better Decisions about Private Loans," here are some of the most common explanations that students and families gave these aid administrators for why they chose to borrow private loans, rather than federal ones:
- Assumed they earned too much to qualify for federal student loans (even though there are no income restrictions on federal loans)
- Were unaware that federal Parent PLUS Loans were available, or could cover up to the full cost of attendance.
- Believed the application process for federal loans was too long and complicated
- Thought that private loans would be disbursed faster than federal loans
- Were attracted by what appeared to be lower interest rates on private student loans
- Did not realize the implications of variable versus fixed interest rates
- Did not want to give their personal information to the government
- Wanted to stick with banks they already do business with
- Parents would not apply and/or qualify for federal parent PLUS loans, but students could get other relatives or friends to co-sign a private loan
Clearly, some of the explanations involve families’ personal preferences. If, for example, a financially needy student’s parents distrust the government so much that they will not apply for federal financial aid, then that individual's options may be limited to private loans, depending on the school he or she wishes to attend.
But many of these other reasons are the result of misunderstandings and confusion that private student loan providers have been only too happy to promote and reinforce through their aggressive advertising.
At Higher Ed Watch, we have shown over the years how some lenders' marketing campaigns (see here and here) have at least implicitly discouraged students from taking out federal loans, by stressing how much easier it is to obtain a private loan than a federal one -- without mentioning, of course, that private loans generally lack the fixed rates, consumer protections, and flexible repayment options that the federal loan program offers.
And despite efforts by Congress to require lenders to provide clearer information about the interest rates and fees they charge, some private loan providers still take advantage of students’ ignorance about how loans work. Case in point: a news release that Sallie Mae issued this month heralding reductions in the interest rates charged on both federal loans and the private loans the company offers:
Students who need extra funding for college can take advantage of changes in the law and improvements in the economy that translate into student loans at among the best interest rates in the last five year period...For college students who need private loans to fill the financial gap, Sallie Mae’s Smart Option Student Loan also offers new, lower variable rates and no disbursement fees. For the upcoming academic year, rates range between 2.25 percent APR and 9.37 percent APR for degree-seeking students, based on today’s LIBOR index.
While the news release is technically accurate, it leaves the misleading impression that the company is offering low-cost loans. As Time Magazine contributor Zac Bissonnette recently pointed out, nothing could be further from the truth. “The rates start as low as 2.25% because interest rates are extremely low right now,” Bissonnette wrote. “But these are variable rate loans which means that, when interest rates are significantly higher in a few years, borrowers’ monthly payments will skyrocket.” In other words, students who are drawn to these loans because of their low teaser rates are in for a nasty surprise.
So what can the new consumer bureau do to ensure that students and their families take out private loans only as a last resort? Tomorrow we will offer our suggestions for what the CFPB should do to help students better understand their options and their debt, and to keep private loan providers honest. Stay tuned.