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Getting Smarter on School Loans

For years, college students and their parents have relied heavily on credit cards, home equity, and private loans to pay for school, according to a recent survey provided exclusively to BusinessWeek. But those sources of cash are drying up. On Aug. 6, Wachovia (WB) joined the more than 150 financial firms that have fled the private student-loan business. And Morgan Stanley (MS) froze home-equity lines for some clients.

In a weird way, the credit crunch may be an important wake-up call for some families who had been financing tuition costs in irrational and expensive ways during the era of easy money and rapidly rising home prices. The growing skittishness of lenders will force more borrowers to exhaust their federal options, a growing pool of funds that typically have lower interest rates and more favorable terms. The fixed rates on a government loan run from around 6.8% to 8%, compared with an adjustable 8% to 20% for a private one. The average credit-card rate tops 13%. “There’s a lot of hysteria that the turmoil in the credit market will mean students can’t get loans,” says Robert Shireman, president of advocacy group Institute for College Access & Success. “But students should be thinking really hard about whether they should be taking out private loans in the first place.”

The Cost of Convenience

A forthcoming survey by student-lending giant Sallie Mae (SLM) and research firm Gallup reveals for the first time just how heavily families have depended on those costly forms of credit. Although 77% of students and 36% of parents tapped into federal funds, both groups usually turned to other sources to supplement that money—sometimes unnecessarily. Some 19% of parents who borrowed money charged tuition on a credit card, while 20% relied on home-equity loans, taking out $10,854 on average. More than one-fourth of the students who used plastic did so merely out of convenience.

Private loans have blossomed as well, growing 27% a year from 2001 to 2007, vs. 7% for federal ones, according to nonprofit education firm the College Board, which administers the SATs. Lenders made the process easy, often requiring consumers to do little more than make a phone call or fill out a basic online form. Financial aid officers played a part, too, sometimes referring bewildered parents to private lenders—a cozy relationship that was investigated by the New York Attorney General. Several financial aid officers at major universities, who allegedly got kickbacks for steering students to certain lenders, resigned amid the scandal in 2007. “Private lenders were very savvy about marketing to students,” says Paula Lull, assistant vice-president at Chicago’s DePaul University.

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