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The Expensive Student Loan Trap

Making its way through Congress (at the usual pace--ketchup coming out of a bottle) is a bill that promises to reform student loans. Called SAFRA for Student Aid and Fiscal Responsibility Act, it would eliminate FFELP or Family Federal Education Program loans. (Doncha love the acronyms?) The bill would knock out bank middlemen who take no risks in making the loans. (The government guarantees them.) Instead, the federal government would lend the money directly to students, saving an estimated $87 billion over the next ten years.

That's nice -- if it passes. But Congress hasn't even nibbled at a bigger student loan problem. I'm talking about private or alternative loans. These are the ones made to students and their familes outside the federal programs. Key players include Sallie Mae, once a government but now a private lender, Wells Fargo, Chase and Citibank.

The problem is that private loans, now utilized by 14% of undergrads (and more grad students), have almost no consumer protections. The result: Young people face a future with huge debts on their backs, debts that will take them 20 or even 30 years to repay. Here are a few of the problems:

  • No limit on interest. Most private loans have a variable rate as high as 18%;
  • No limit on origination fees. Usually they range from 3% to 4.5% of the loan;
  • No Schumer box, like the one used for credit card offers, that would disclose to 18- and 19-year-olds who know nothing about finance the true cost of the loan;
  • No way out. Lenders will not cancel or mitigate a student loan even if the borrower drops dead or becomes disabled. Any co-signer is similarly on the hook. Even if a school turns out to be a complete fraud that never provided any education, the student must repay. Student loans are not dischargeable in bankruptcy, and payments can be subtracted from Social Security payments.
Worse yet, the loans are almost impossible to amortize. Many start accruing interest while the kid is still in college; so by graduation his $30,000 loan may turn into $40,000. Say he can't find a job or loses one; he can ask the lender for "forebearance" -- a year-long delay in repaying, but, again, interest accrues so the borrower winds up paying interest on interest. And God help anybody who defaults! The cost of collection is added to the bill along with accrued interest. And, while the federal government allows borrowers to vary payments so that they're a reasonable percentage of income, banks making private loans show no such mercy to those with modest salaries.

The Federal Reserve issued new rules to go into effect on February 10, but they are pretty wimpy. Generally, they require lenders to provide uniform disclosure of terms to prospective borrowers before they sign on. You'd think they would have done that already.

How does it all play out? Well, here's one of many sad testimonials from former students compiled by Student Loan Justice.org, an advocacy group:

It cost 18,000/semester to go to Washington University School of Medicine, Program in Occupational Therapy. My student loan total was 68K when I graduated...I could not find a job for 9 months. The first job I took I made 38K, living in Chicago, with a $900/month student loan payment (that's 55% of take home pay). Sure, they let you delay your payments, but your load just grows and grows... So, now its 10 years later, after making payments for 8 years of that time (on and off due to financial strains/changing jobs/moving, etc), my loan totals are now 103K. So I paid close to $25,000 over the years and my loans have increased in total by $35,000.
College financial advisers tell students and their parents to exhaust all the federal options before taking out a private loan, and that makes sense. Two-thirds of borrowers foolishly don't even bother to get the government aid to which they're entitled, according to the Project on Student Debt. But the Fed loans max out at $5,500 for freshmen -- leaving a gap when compared to the full cost of college, about $6,500 at state schools ($10,000 more for non-residents) and $25,000 for private institutions, according to the College Board. Parents could resort to government PLUS loans or take out a home equity loan, if they can get one, but putting themselves in hock when retirement funds and homes have dropped in value may not be a winning personal-finance strategy. Mark Kantrowitz, the brain behind Finaid.org, which guides students to scholarships and loans, suggests that students avoid over-borrowing. "If your loan is equal to your first year's salary, you'll probably make it," he says. "But if it's twice what you're expecting to earn, you could be headed for default."

All that's fine for people who are borrowing now. But what about those who are already mired in a debt the size of a mortgage with the terms of a credit card? Right now there are no answers whatsoever.

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