Pulling Back the Curtain on Private Loans

March 4, 2008

By this point, anyone who hasn't gotten the message that college students' escalating use of private (or "alternative") loans are a source of concern hasn't been paying attention to national discussions about financial aid. The College Board and the National Association of Student Financial Aid Administrators, are among the groups that have issued reports documenting student borrowers' growing use on the loans and suggesting policy changes that might diminish that reliance, and some colleges have gone out of their way to alter their students' behavior.

But for all the talk of potential overdependence on private loans as a public policy concern, which has also been a theme of Democrats in Congress, relatively little has been written or said about exactly why the loans can become a problem for students, beyond the relatively obvious reason: their higher cost.

The National Consumer Law Center sought to close that gap in a report released Monday. The title of the report, "Paying the Price: The High Cost of Private Student Loans and the Dangers for Student Borrowers," makes its perspective clear; the consumer advocacy group and its officials have paid increasing attention in recent years to private student loans as a potential hazard for vulnerable consumers and argued that governments should regulate private student loans as rigorously as they do other sorts of consumer loans.

But if the law center's report makes a contribution to the public's understanding of and knowledge about the impact of private student loans, it is not in its rhetoric but its examination of the terms and conditions of 28 actual private student loans, issued between 2001 and 2006, that the center analyzed. "We had really been struck that in the debate on private student loans, nobody had really taken the opportunity to go through a bunch of loans and see where the actual nitty-gritty problems are," said Deanne Loonin, a staff lawyer at the consumer law center who was a member of the U.S. Education Department panel last winter that negotiated possible new federal rules to govern student loans.

Not surprisingly, perhaps, the consumer group's analysis starts with the pricing of the loans, which have been the focus of the discussion to date. The average annual interest rate of the loans the group examined was 11.5 percent, with the highest close to 19 percent. The average margin of the loan (the amount by which the interest rate charged to the borrower exceeds the rate paid by the lender) was 4.8 percent, but some of the loans had margins of nearly 10 percent -- "shockingly high," the report says. The average loan came with origination fees (a one-time fee borrowers pay to take out the loan) of 4.5 percent of the total loan volume, but some of the loans charged a fee as high as 9.9 percent.

As concerning as those high costs to borrowers are, though, Loonin said, potentially "more insidious" are the aspects of the loans that have drawn relatively little attention to in the discussion about private loans so far -- the "hidden bombshells" in loan agreements that either limit borrowers' ability to fight the loans in court or that limit the sorts of objections that borrowers can make to the terms later on.

A majority of the loans, for instance, contained mandatory arbitration clauses -- which the center characterized as "hallmarks of predatory loans" -- that require borrowers to agree to enter arbitration rather than challenge problems with loans or their schools of choice in the future. Other provisions in the loans seek to "limit a borrower's ability to raise defenses to the loan based on violations of the law or that the lender breached the contract or that the consumer does not owe the amount claimed." And some of the loans "stated explicitly that there will be no cancellation if the borrower or co-signer dies or becomes disabled," the report notes.

The law center's report also draws a number of parallels between the private student loan market and the subprime mortgage market whose collapse is now helping to drag down the national economy, which it calls a "sad deja vu." Among the similarities it cites are a lack of regulation and enforcement; "outsourcing of social goals" -- "Higher education and asset accumulation through homeownership are keys to upward mobility in this country; both social goals have been largely outsourced to private market;" risk-based pricing, charging the highest price to the supposedly riskiest borrowers.

And it suggests a set of principles that should guide any legislative effort to alter the private student loan market, including:

  • Eliminating unsustainable loans and develop fair underwriting standards.
  • Eliminating incentives for schools and lenders to steer borrowers to abusive loans.
  • Improving disclosures so that borrowers can know the true cost of private loan products and understand the difference between private and government loans.
  • Requiring accurate and accountable loan servicing.
  • Ensuring effective rights and remedies for borrowers caught in unaffordable loans.
  • Preserving essential federal and state consumer safeguards.
  • Improving assistance to distressed borrowers.

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