Private College Loan Perils

Nearly 50% of undergraduate private student loan borrowers fail to exhaust their low-cost federal student loans to finance their college education.
--Consumers Union report

Alison Rabil, the director of financial aid at Barnard College, became concerned one day when she was examining figures on the number of students at the women's college who were taking out private loans.

Rabil and others in Barnard's financial aid office certainly understood why private loans should be a last resort. But the school's parents, even though many were college educated, didn't appreciate the potential hazards of a private loan, which is the fastest growing source of student debt in the country.

Consequently, the school in New York City decided to educate its moms and dads. When Barnard learns that a family is on the verge of assuming a private loan, the school arranges a phone interview with parents. After conversations with Barnard staffers, families often abandon their plan to rely on a private loan. Thanks to Barnard's initiative, according to Inside Higher Ed, an online industry publication, the volume of private loans at the school plummeted by 73%.

If you're not sure why private loans should be a last resort, keep reading. Here is what you need to know:

Private loans charge variable interest rates. Anyone with an adjustable rate mortgage already knows why loans without ceiling caps can be perilous. A loan with runaway payments can wreak havoc on a student's or parents' budget. Many people don't realize that private loan payments, which might initially seem manageable, will change because most private loans include variable interest rates that lack a ceiling cap.

Private lenders can discriminate. Unlike federal loan programs, lenders that market private loans can pick and choose their customers. Families with excellent credit can obtain better starting interest rates than those with average or worse credit histories. The less fortunate borrowers can get saddled with loans as bad as the subprime mortgages that helped smash the housing bubble. The spread between the starting interest rate for stellar customers versus those stuck with the worst rate can be 10 percentage points or more.

What's more, the interest rates and fees of private loans can vary from school to school. Some lenders take into account a school's overall loan default rate. So even if you have a pristine credit history, you could still get punished.

Private loans can be confusing. Many families who end up with a private loan believe they have secured a federal loan. Sometimes they don't even realize the mistake they made until they try to consolidate the debt with federal loans. There are many reasons for the confusion. First, the loan process can be bewildering. And families, after surviving the college matchmaking process, may hardly be in the mood to sort through loan possibilities in the spring and summer leading up to a child's freshman year.

Parents and students just want the cash, and they figure they'll worry about how to pay it back later.

If you're considering a private loan, here is what you should be doing: