The Credit Squeeze and Student Loans

Stories in the media and announcements by some lenders have led to questions and confusion about the availability of loans for students in college now or entering college in the fall. Here's the scoop.

What's happening? What's all the fuss about?

Mostly because of problems in the mortgage market, there was a dramatic decline in the number of investors willing to purchase some types of financial instruments (especially auction-rate securities). Some student loan companies have been using these methods of financing to raise money to make student loans. Some banks sell their loans to companies that used these financing methods. With the unexpected loss of financing, these companies have been forced to stop or reduce their lending. Changing their financing methods can take time, especially because no one is quite sure what financing models will succeed in addressing investor nervousness, and when.

What does this mean for students and their parents?

For federal loans, which is the type most people have even if the loan comes from a bank, everyone will get the loans they are eligible for. The biggest issue that some will experience is that the lender they used last year is not making loans this year. In those cases, students will have to choose a different lender.

What if students can't find a lender willing to make a federal loan?

That's highly unlikely, and the federal student loan program already includes safeguards to take care of that problem if it were to occur. There are more than 2,500 lenders in the system, and only a few dozen have announced changes in policy. Banks like to make student loans because the loans are guaranteed by the federal government -- there's no danger that the loan won't be paid back, even if the economy gets worse and the borrowers are unemployed. That makes federal student loans an especially desirable investment in today's shaky economy.

That said, the current lack of liquidity in the credit markets, if it goes on for too long, will effect more and more lenders. Fortunately, Congress has taken action to provide liquidity to the federal student loan program by allowing the U.S. Department of Education to purchase loans made by banks. Furthermore, if an eligible student at an eligible school can't get a federal loan, there are intermediaries empowered to make "lender of last resort" loans. In addition, students and parents can get the loan funds directly from the federal government through their school's participation in the Direct Loan program.

In short, while some lenders are scrambling to fill a financing gap, the system is quite secure for students. That's why we can say with confidence: everyone who qualifies for and wants a federal student loan will get one.

What about students who need private student loans?

About eight percent of undergraduate students take out private or state-sponsored loans that are not federally guaranteed. Most of these loans are to borrowers with good credit records: they are not likely to experience any problem in getting an education loan, though, for the reasons described above, some of the lenders they have used in the past may no longer be making loans, at least temporarily. So they may have to switch lenders, and the interest rate might be a little higher.

Students or parents with no credit history or a poor credit history will have more difficulty getting a private student loan than they did in the past. This may be especially true at technical schools with low graduation and job placement rates. To address this gap, Congress has increased the amount that students may borrow in the federal programs.

What should families do if they're having difficulty getting a private student loan?

See our Consumer Guide: Student Loan Options in a Tight Credit Market.

Families should make sure they are exhausting all of their federal options. Most parents (even those with no credit history) are eligible for federal PLUS loans. If a parent's poor credit history makes them ineligible for the PLUS loan, then the student is entitled to additional federal loans.

If private loans are the only route, then finding a credit-worthy cosigner can help a lot. But first make sure that the school is the right fit and really worth the money. A warning to any student considering a high-interest-rate private loan for a short-term training program: be very skeptical of any claims the school makes about your future job prospects and your ability to pay off the loan. If you have doubts, seriously consider a different program or a different school.

Also, students should apply for private scholarships that could reduce the amount they need to borrow.

Are there any other factors contributing to loan companies exiting the federal loan program?

Until recently, most federal borrowers had interest rates on their loans that would adjust each year. In 2002 to 2005, interest rates were at historic lows, and federal rules allowed borrowers to lock in those rates by taking out a federal consolidation loan. (The government still pays the lender the higher rate as interest rates in the economy increase). A number of student loan companies were created or grew quickly in those years to take advantage of the billions of dollars of consolidations that were occurring because of the low rates. However, since July 1, 2006, rates on new federal loans have been fixed, so the market for consolidation loans is drying up. In addition, federal subsidies to lenders making consolidation loans were reduced last fall (subsidies on other federal loans were also reduced, but not by as much).

Some of the lenders that have announced they will end or reduce their participation in the federal student loan program had a major focus in the consolidation market.