Federal Plan About to Shake Up Student Loans

The U.S. Department of Education will soon unveil a plan that is expected to let millions of indebted former students into the direct lending program for the first time and spur a virtual cat fight for college consolidation loans.

Direct lending, a controversial program that lets students bypass banks and get loans directly from the federal government, allows easier repayment terms. Currently, however, the program is offered only through about 5% of the nation’s universities, colleges and trade schools.

Direct lending’s portion of the student loan market could soar overnight, thanks to the loan consolidation program expected to be revealed next month. The plan would allow former students and some who are still in school to refinance old bank loans with direct loans from the federal government.

“All students who are in repayment on federal loans will be given the opportunity to consolidate into a direct loan,” said a spokeswoman for the Education Department in Washington. “They will have to contact their current lender first, but if that lender doesn’t offer an income-contingent repayment plan that’s acceptable to the student, they will be able to get a direct loan.”

The Education Department is not going to second-guess students who say the loans they were offered were unacceptable, she added, so virtually anyone who is paying off a student loan will be able to convert the debt via a direct loan.

News of the government plan already has prompted a flurry of activity among lenders.

The end result for college students is a widening array of complex choices--some offering real benefits, others offering risks and high costs.

In a loan consolidation, a student simply refinances all--or a portion--of the old student loans into one new one. In the past, there was no interest rate benefit to consolidating these loans, but a borrower could pay a smaller amount over a longer period of time and make the payments to one lender.

Now, the Student Loan Reform Act will create real interest rate disparities between different types of consolidation loans. In a nutshell, if you consolidate your loans under the Federal Family Education Loan Program, or FFELP--the loans handled by banks--the interest rate is the weighted average of what you are currently paying, rounded to the next full number. In other words, if your average rate is now 8.57%, you’d pay 9% when you consolidated the loan. That rate is fixed for the life of the loan.

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Under the direct loan consolidation program, the interest rate will equal the Stafford loan rate at the time you get your loan. Right now, that rate is attractive. The Stafford rate is variable, adjusted once each year. The current variable rate is 7.43%, but it is capped at 8.25%. Translation: The loan rate can go below 8.25%, but it can’t go higher.

For students who have old Stafford loans at 10% interest, direct loan consolidation is clearly a bargain. You can get these direct loans with standard 10-year terms or with graduated payments.

The direct loan program offers an array of other repayment options aimed at making the loans more affordable for students who want to go into important, but low-paying professions such as teaching and social work.

For instance, where conventional student loans require borrowers to pay off the debt within 10 years, the direct loan program would allow them to stretch the payments over far longer periods--for up to 30 years.

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One option, called income contingent repayment, drops payments to whatever level is necessary to suit the borrower’s income. Those with very modest earnings may even pay less than the interest due--impossible with ordinary student loans.

There is a compelling downside to the easy-repayment terms, however: When you pay over longer periods, you pay more. That’s simply because the interest you owe is calculated based on the balance of your loan. When you pay over longer periods of time, the balance is whittled down more slowly, and that boosts the interest cost.

Thus, a student with $25,000 in loans would pay about $300 a month--a total of $36,000--to pay off the debt in the standard 10 years, according to the Education Department. With a 20-year extended repayment plan, the student would pay about $200 a month, or a total of $48,000 over the life of the loan.

Borrowers who use the income-contingent option can face an even costlier prospect. That’s because under this program they are allowed to pay less monthly than the interest accruing on the loan.

The result is called negative amortization. It means the loan balance grows--and you owe interest on a steadily increasing amount--even though you are making all the required payments. In the worst-case scenario, an income-contingent borrower could see the loan balance balloon to 150% of the original debt.

If the loan isn’t paid off in 25 years, the government will “forgive,” or cancel, the remainder of the debt. But be aware that any amount of debt that’s forgiven is considered taxable income, so you could be faced with a whopping tax bill in exchange.

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Kathy M. Kristof welcomes comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.

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A Debt ‘Refi’ Can Be Costly

Anyone with a student loan is likely to be bombarded with information about “loan consolidation” in the next few months, as a new government program will inspire competition in this otherwise staid segment of the lending industry.

Student loan consolidation programs allow you to roll several old loans into one new one, which can save you both time and money--sometimes.

But students need to be cautious.

Consider the new student loan consolidation plan offered by University Support Services, headquartered in Washington, D.C. Despite the official-sounding name and address, U.S.S. is a private lender.

Unlike federal student loans, there are no payment deferrals with private loans. If you don’t pay, you’ll hear from debt collectors and your credit rating will be shot. There is no “cap” on the U.S.S. variable interest rate, and there is a 5% loan origination fee.

Under the government’s so-called “direct loan” consolidation program the most you’d pay in annual interest on a $25,000 loan would be $2,062.50 with the rate cap. With the U.S.S. loan, you would pay $3,527.50 if interest rates are as they were for the last 13 years and average 14.11%. When you add that to the $1,250 origination fee, this loan costs roughly $2,715 more than the federal loan in the first year. Over the life of the loan, the sky’s the limit.

So what’s the advantage of this loan?

Private loans such as U.S.S. makes allow you to consolidate many kinds of loans, including credit card debt, as long as the money was spent to finance your college education, says Pierre Escandar, U.S.S. executive vice president.

In other words, this loan offers convenience by allowing you to write just one check each month to pay student debts. U.S.S. also says it’s committed to superior service, and Escandar predicts people will pay extra for these benefits. “It’s why people use Federal Express rather than UPS,” he says.

But Here’s a question for you graduates: Is a little extra convenience worth upward of $2,715? The way you answer will determine how good your parents feel about sending you to college.