Impact of the Credit Crisis on Student Loans (continued)

As noted previously, lenders have adopted more stringent credit underwriting criteria for private student loans. Not only are the lenders requiring higher credit scores of borrowers and cosigners, but more borrowers are being required to have a cosigner. Also, even borrowers or cosigners who have good credit scores are being denied because of secondary criteria such as volatile income or self-employment. About a third of borrowers who might have qualified for private student loans in early 2007 are now finding their applications rejected.

Lenders cannot control interest rates and fees on federal education loans, since the maximum rates and fees are set by law. They can, however, increase costs to the extent that they were previously offering discounts on those rates and fees. The majority of lenders have eliminated all back-end discounts except a 0.25% interest rate reduction for auto-debit. This is partly because profit margins have narrowed considerably and partly because any lender who intends to sell their loans to the US Department of Education through ECASLA cannot offer better discounts than those offered by the Department. After all, it is the lender that holds the loan during repayment that pays for the back-end discounts, not the lender who originates the loan.

 

However, Congress passed a phased-in interest rate reduction on the subsidized Stafford loan for undergraduate students as part of the College Cost Reduction and Access Act of 2007. The interest rate dropped to 6.0% in 2008-09 and 5.6% in 2009-10, and will be dropping to 4.5% in 2010-11 and 3.4% in 2011-12, and then back to 6.8% in 2012-13. The interest rates on subsidized Stafford loans for graduate and professional students and on all unsubsidized Stafford loans remain at 6.8%.

 

Lenders do have pricing power on private student loans and have been passing on their increased cost of funds by increasing the interest rates and fees on new loans. Private student loans typically consist of a variable rate index, such as the Prime Lending Rate or the 1-month LIBOR index, plus a fixed rate margin. (The fixed rate margins are typically offered in four to six tiers that depend on the borrower’s credit score. There may also be a separate set of tiers for borrowers with and without cosigners.) Lenders have increased the margins on their loans by 2% to 4% since the start of the credit crisis. The variable rate indexes have decreased at the same time, yielding an overall average interest rate that is only about 1% higher than in early 2007. However, borrowers need to be concerned not just about the current “teaser” rates on the loans, but how high those rates may increase over the life of the loan. If the LIBOR index can drop by 3% in twelve months, it can just as easily jump by 3% in a year. So a variable rate on a private student loan that is currently competitive with the fixed rate on the PLUS loan may ultimately be much more expensive over the 20 or 25 year life of the loan. Index rates will start increasing soon after the end of the credit crisis. Borrowers with excellent credit who are enticed by current low interest rates should realize that those rates may increase a lot just a few years from now.

There are already some signs of the start of a recovery in the capital markets. Several lenders have succeeded in securitizing private student loans for the first time since 2007. Lenders have also made modifications in their private student loan programs to make it easier for them to be securitized. For example, Sallie Mae replaced its Signature Student Loan with a new Smart Option private student loan. The Smart Option loan requires borrowers to make interest only payments during the in-school and grace periods. Not only does this avoid negative amortization and helps borrowers repay the debt sooner, but the improved cash flow and likely decrease in defaults will make it easier for the lender to raise capital for the loans.

 

Unemployment rates will likely peak in late 2009 or early 2010. At that time there should be an increase in the momentum of student loan securitizations in the capital markets, making it easier for lenders to raise funds for education loans. This should lead to an easing of the availability and eligibility restrictions that have affected private student loans, and may also lead to a decrease in the cost of the loans.

 

In the meantime, President Obama’s budget proposals for an expansion and reengineering of the Perkins Loan program, if enacted, will provide $4.9 billion in additional Perkins loan volume per year. This will shift some borrowing from private student loans to federal loans, especially among students who are no longer able to obtain private student loans.