Students’ First Lesson: Beware Loans' Fine Print
HIGH school seniors, thrilled at receiving fat envelopes from the colleges of their choice last month, must now figure out how to pay for the privilege of attending these institutions. For many, this will mean a journey into private student loan land, where financial fog and fine print reign.
At around $20 billion, the private student loan market is less than one-third the size of various federal lending programs. But students may have to rely more heavily than usual on banks and other private lenders this year because two alternative sources of tuition funding — the 529 plans and home equity balances — have been slammed by declining stock market and property values.
According to the Project on Student Debt, the average graduate leaves college shouldering $21,900 in student loans. These loans cannot be discharged by filing for personal bankruptcy.
Student Lending Analytics, a company that helps universities analyze lending programs, estimates that today’s average private loan has an annual interest rate of 11 percent. Many of the loans have rates that fluctuate, so costs for those borrowers will go up when prevailing interest rates rise.
As with all borrowing, making the right decision on a student loan is paramount. But lenders make this harder than it should be.
The top three private lenders are Sallie Mae, which underwrote $6.3 billion in loans during 2008; Citibank, with $1.8 billion in loans last year; and Chase, which made $1.1 billion in loans during 2007.
But disclosures on various lending practices differ vastly. For example, lenders do not disclose all fees charged in the servicing and collection of student loans, and loan contracts do not always include benefits that are promised in lender advertisements — like the possibility of a lower interest rate after graduation.
Most troubling, some lenders ask students to sign promissory notes obliging them to pay off their loans before they are told what interest rate they will be charged.
“This is a very opaque market where established lenders want to win on brand name and not on price,” said Tim Ranzetta, the founder of Student Lending Analytics. “The Federal Reserve is looking to improve the transparency, but until it does, it is business as usual.”
To assess various offerings, Mr. Ranzetta applied for student loans from seven of the largest lenders. He reviewed the disclosures during and after the application and combed through the promissory notes the lenders provided.
He said he was surprised by what he found. The range of interest rates on fixed-rate loans was wide — 7 percent to 12 percent — and the larger lenders charged the highest rates. In the fine print of the promissory notes, he discovered that some lenders — Chase, PNC Financial and SunTrust Bank — can raise interest rates by two to three percentage points if a borrower is late with a single payment.
Thomas A. Kelly, a Chase spokesman, said the language in the note comes from a contract used by a company the bank bought several years ago. But Chase has not raised the interest rate for borrowers when they are late, he said.
Hugh Suhr, a spokesman at SunTrust, said that raising the rate had never been automatic and that the bank’s primary interest was in working with borrowers toward resolutions.
There are also differences in how lenders apply excess payments made by borrowers. Say a monthly loan payment is $200 but a borrower submits $400. Most lenders apply the extra amount first to any late fees that have been charged, then to accrued interest and finally to principal. But for its private loans, Sallie Mae applies excess money only to future payments, making it tougher for a borrower to pay down principal faster. Sallie Mae said if students made a special request, it would apply excess payments to principal.
Fixed-rate loans aren’t the only options available to borrowers. But costs on variable-rate loans, based on a specified interest rate index like the prime rate, are high, Mr. Ranzetta found. Loans of this type made by Chase can reach 13.57 percent, while at Sallie Mae they come in at 14 percentage points over the London InterBank Offered Rate, which is currently just under 2 percent.
With short-term interest rates in the cellar, the profits on such loans are immense. Meeting with investors last December, Sallie Mae officials said that its average interest-rate spread on variable loans was 10 percentage points.
Martha Holler, a Sallie Mae spokeswoman, said, “Although we could narrow our range of private loan interest rates and also narrow our lending, we feel strongly that we should serve as many students as we can.”
Mr. Kelly at Chase said: “These loans are unsecured and the rate is tied to the credit history of the borrowers.” (Most students, of course, haven’t had much time to build up their credit histories.)
While some borrowers may think that variable-rate loans allow them to benefit from low interest rates, that goes only so far. Wells Fargo, for example, puts a floor of 4.75 percent on the prime rate index it uses to price its loans. As a result, when the prime rate falls below that point, Wells’s borrowers don’t see their costs decline.
Lisa B. Westermann, a Wells Fargo spokeswoman, said the interest rate floor was a result of “historic low interest rates and the economic environment, which has created higher lending costs and losses resulting from defaulted loans.” The bank took this approach, she said, instead of charging a higher rate over the life of the loan.
ARMED with his findings, Mr. Ranzetta has created a rating system for student loans at studentlendinganalytics.com/SLA/ratings.html. His company does not receive financial support from lenders or financial services firms; it relies solely on consulting fees from universities it works with.
As the Federal Reserve ponders new disclosure rules for student lenders, Mr. Ranzetta says he thinks regulators should require lenders to disclose any interest rate adjustments that would occur as a result of late payments or other events. He also suggests that the Fed make lenders detail all fees charged over the life of the loan, such as those levied when a borrower cannot make payments.
Lenders should also include a plain-English disclosure of loan terms in the lending process, Mr. Ranzetta said, and incorporate a loan’s advertised benefits in the promissory note to make them contractual obligations. Making sure borrowers know they cannot erase student loans in bankruptcy is another must, he said.
Last week, the House of Representatives passed legislation that would protect consumers from deceptive credit card practices and opaque disclosure. Scrutiny should now turn to private student loans, especially those that take advantage of young adults who are naïve about finance and the perils of debt.