In the Press – The Wall Street Journal – The New Math of Student Loans

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For borrowers with strong credit, private lenders now often offer the best deals. Here’s a crash course.

When it comes to student loans, a little homework can lead to big savings.

Over the next few weeks, hundreds of thousands of students and their parents will apply for student loans for the coming college year. Many students will sign up for federal loans, where they will find the best deals.

But for a certain group of applicants—undergraduate students with creditworthy parents and graduate students with high credit scores—student loans from private lenders, long associated with high interest rates and stricter repayment terms, are becoming more borrower-friendly and could help them save thousands of dollars over the life of a loan.

In addition, a growing number of private lenders allow borrowers to refinance their existing loans at a lower interest rate.

The deals are being offered by both traditional banks and nonbank lenders. David Carter, a 30-year-old M.B.A. student at New York University’s Stern School of Business, signed up for a 10-year private student loan of about $100,000 this month from New York-based nonbank lender CommonBond, which specializes in student loans, for the coming academic year.

His fixed interest rate will be 5.34% once he starts repaying the loan, lower than the federal government would have charged him. Mr. Carter says he estimated he will save nearly $11,000 over the life of the loan.

“I had just assumed I was going to take out federal loans [but] I realized rates were a lot higher than I thought they were going to be,” says Mr. Carter, who plans to pursue business development in the tech sector after he graduates next spring.

For decades, financial advisers, guidance counselors and other experts have advised students and their parents to sign up for federal loans before seeking out private loans. But that strategy doesn’t reward parents who have high credit scores and are financially comfortable, because every applicant who gets approved for a federal loan—no matter what their credit score is—ends up with the same interest rate.

By contrast, private loan rates are determined based largely on the applicant or parent’s credit as well as documentation of their income.

Lower rates and more flexible repayment terms give borrowers more of a reason to shop around for student loans before committing to a particular lender. Here is what students and parents need to know:

Taking the Federal Route

Interest rates on private student loans vary widely by lender, the borrower and the type of loan. Borrowers should first take a look at what federal loans cost.

First, students should file the Free Application for Federal Student Aid (fafsa.ed.gov ), which is required to find out whether they are eligible for federal student loans.

The most affordable federal option is a subsidized Stafford loan, named for former Vermont Sen. Robert Stafford. With this loan, the federal government, not the students, pays the interest charges during college and during certain other periods.

Subsidized Stafford loans aren’t limited to low-income families: Families with higher incomes whose children attend expensive colleges also may qualify. Just over 34% of undergraduates with family income of $100,000 or more received such loans at colleges where total annual costs, including tuition and room and board, were at least $30,000 in 2011-12, according to an analysis of the most recent federal data by Edvisors.com, which tracks financial aid.

In addition, borrowers also can get unsubsidized Stafford loans, on which borrowers must pay all the interest charges, and Plus loans, which are intended for graduate students and parents of undergraduate students. Most families can qualify for both types of loans.

Federal loans will be cheaper for the coming academic year. Beginning July 1, interest rates will be 4.29% for Stafford loans for undergraduates, down from 4.66%. The rate on the federal Plus loan will be 6.84%, down from 7.21%. The loans’ rates are pegged to the final auction of the 10-year Treasury notes each May, on which the high yield last month was 2.237% compared with 2.612% a year prior.

Going Private

Unlike federal loans, most private lenders require undergraduates to have a cosigner to qualify for a loan. Students whose parents have high credit scores stand to pay the least in interest. Such families should shop around for lenders that are offering fixed rates below the Plus loan’s 6.84%.

SunTrust Banks, for example, currently is charging fixed interest rates between 4% and 10.50% on its loans, which range from seven to 15 years. The rates include a three-quarters of a percentage point discount for borrowers who apply and get approved between this month through August.

Citizens Bank, a unit of Citizens Financial Group, charges interest rates of as little as 5.75% for undergraduate fixed-rate loans. The lowest fixed interest rates at SLM, better known as Sallie Mae—the largest private student lender by origination volume—and Discover Financial Services are currently 5.75% and 5.99%, respectively. Yet the rates charged by these lenders can reach nearly 12% or 13%.

Borrowers often can get a quarter of a percentage point discount on their interest rate when they arrange for their monthly payments to be made automatically. Some lenders offer an additional discount for borrowers who have a checking account or other relationship with them.

The lowest interest rates are usually reserved for borrowers with the highest credit scores. Less than 10% of borrowers received the lowest advertised interest rates based on an analysis of 10 years of private student-loan securitizations through 2007 by Mark Kantrowitz, publisher of Edvisors.com.

The average FICO score for private student-loan borrowers can be high. At Sallie Mae, it was 748, on a scale that ranges from 300 to 850, for the borrowers who had loans originated in the first quarter of 2015, according to the company.

Graduate students seeking loans should consider a similar strategy. Unlike undergraduates who have a limited or no credit history because of their age, graduate students often have had credit cards, car loans or other loans for several years before they apply for loans for graduate school.

The rates to beat will be the Plus loan’s 6.84% and the graduate Stafford loan’s 5.84% for the coming year.

At CommonBond, which provides loans to students enrolled in 20 M.B.A. programs at prestigious universities, including Columbia, Duke and NYU, every borrower gets an interest rate of 5.59% on a 10-year loan, lower than both of the federal graduate loans. To get approved, says Chief Executive David Klein, they will need a FICO score in the high 600s.

The other option—though much riskier—is a variable-rate loan, which is offered by nearly every lender. Before the recession, most private lenders offered only variable rates. Federal student-loan rates are currently fixed, a feature that nearly every private lender has made available to students in the last four or so years.

Variable interest rates can reset monthly and are generally tied to the one-month or three-month London interbank offered rate. While rates on these loans are currently as low as around 2% for borrowers with the best credit, they could rise substantially over time, especially if the Federal Reserve begins raising rates, as expected.

Tiffany Baker, a 34-year-old undergraduate at Oregon Health & Science University in Portland, signed up for three private student loans from Sallie Mae during the past three years, in addition to receiving federal student loans and free aid. Her private loans total about $70,000 and have variable interest rates that range between 2.25% and nearly 5%, she says.

Ms. Baker, who is studying radiation therapy, says she asked her mother to join her as a cosigner on her loans to get lower interest rates.

Comparing the Real Costs

In addition to interest rates, find out whether lenders are charging origination fees, a percentage of the loan amount that borrowers must pay to get the loan, which is typically either deducted or added to the loan amount.

Most private student loans no longer come with origination fees, though they are standard with most federal loans. Fees for all Stafford loans are 1.073% of the amount borrowed, while Plus loans come with a 4.292% fee. The amounts are set to decline on Oct. 1 to 1.068% and 4.272%, respectively.

Borrowers should consider these additional costs when comparing private and federal loans. To get a $30,000 Plus loan, for example, you would have to borrow $31,345, with a 4.292% fee, compared with a flat $30,000 with most private student loans.

Borrowers who receive a 6% fixed interest rate on a $30,000 private student loan would pay $9,967 in interest over the life of a 10-year loan, compared with $12,018 with a 6.84% Plus loan.

Make sure to factor in the repayment period that private student lenders are offering. Those periods can be as short as five or seven years, which can make a monthly payment much larger than the standard 10-year period for Stafford and Plus loans. The repayment period for most private loans is between 10 and 15 years.

Refinancing Student Loans

Refinancing is common in the mortgage market, where homeowners have for decades replaced an existing mortgage with a new one with a lower interest rate. That practice now is getting more common among private student-loan borrowers.

San Francisco-based Social Finance, better known as SoFi, launched in 2011 as a refinancer of student loans. It has refinanced $600 million of student loans—both federal and private—in the first quarter of this year, up from $158 million for the same period a year prior and $6 million two years prior.

Others have followed suit. Navy Federal Credit Union, the largest credit union by assets in the U.S., began refinancing private student loans this past April. Citizens Bank started refinancing private and federal loans last year.

Some of the lowest interest rates are being offered to borrowers who are refinancing. Darien, Conn.-based Darien Rowayton Bank, for example, is offering fixed rates of between 3.5% and 6.25% on refinances or 1.90% to 3.98% on variable-rate loans. SoFi’s rates range between 3.5% and 7.24% and 1.90% and 5.19%, respectively. However, the lenders say that more than 15% and “well over” 5%, respectively, of their borrowers get their lowest rates.

Some lenders are watching each other’s rates closely and dropping their rates to stay competitive. That has led to lower rates for borrowers lenders find most desirable. At CommonBond, for example, the average refinancer is 32 years old, has a 760 to 770 FICO score and around $140,000 in annual income.

Ali Khan, a 34-year-old physician in Syracuse, N.Y., says he refinanced about $200,000 of federal student loans with SoFi in January. He had signed up for a total of 16 federal loans to pay for medical school, and their interest rates ranged from 5.8% to 8.25%. By refinancing, he says he received one new loan from SoFi with a fixed interest rate of 4.5%.

“To be able to find an institution to refinance my federal loans at almost half the rate was a miracle,” he says. “It will literally save me tens of thousands of dollars over the life of my loan.”

Borrowers should consider the benefits they give up when they refinance federal loans into private ones, including debt forgiveness for public-service jobs and the option of postponing payments during long periods of financial hardship.

Modifying Your Loan

For years, private student loans were notorious for not offering flexible repayment terms to borrowers who encountered financial difficulties.

Federal student loans, by contrast, have traditionally allowed for long periods of payment postponements without reporting the borrower as being late—a feature that is used by millions of borrowers who have a difficult time finding employment after graduation or encounter some other setback.

Federal loans also give borrowers the option to lower their monthly payments to a level based on their monthly income and can allow part of the loan balance to be forgiven.

After being pressed by the Consumer Financial Protection Bureau, several lenders have rolled out modification programs that offer to lower monthly payments temporarily or permanently for borrowers who are facing a financial hardship. Qualifying varies depending on the lender, though many require borrowers to show evidence of hardship, whether it is unemployment checks or medical bills.

Wells Fargo last year began lowering interest rates to as low as 1% for eligible borrowers who are up to 120 or 130 days behind on payments and for borrowers who are current on their loans but can prove they are at imminent risk of falling behind. The reduced rate is valid for at least 12 months.

In February, Wells Fargo began extending the repayment period by as much as five years to lower borrowers’ monthly payments. Borrowers can qualify for both the interest-rate reduction and repayment extension. The bank says that most of its borrowers are on time with their payments, but that it has modified more than $15 million of private student loans so far.

Also last year, Discover began allowing some borrowers to make temporary interest-only payments or minimum payments of at least $50—an option that in most cases is open to borrowers who are less than 60 days late and who weren’t previously in a similar repayment program.

Sallie Mae has been offering modification options the longest out of its competitors. In 2009 it began extending repayment periods or reducing interest rates for borrowers who are up to 119 days behind on payments.

Borrowers should contact their lender if they are experiencing hardship and ask about loan-modification options.

By AnnaMaria Andriotis

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