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Shopping for the best private student loans

Private student loans can be helpful or they can drown you in debt. To steer clear of trouble, be aware of your options and take the following steps.

Students need to do their homework:
1. Complete the FAFSA.
2. Don't forget federal deals for parents.
3. Ask private lenders lots of questions.
4. Scrutinize private student loan discounts.
5. Consider paying interest ASAP.

1. Complete the FAFSA. That's the free application for federal student aid, including grants and low-cost loans.

"Federal loan programs will be more advantageous," says Dallas Martin, president of National Association of Student Financial Aid Administrators. "They'll have certain borrower benefits that aren't always available with private loans. Private loans should be the last resort."

2. Don't forget federal deals for parents. Parents may balk at borrowing, but experts urge them to consider the federal PLUS program.

As of July 1, 2006, rates were fixed at 7.9 percent for loans from the Federal Direct Loan program and 8.5 percent for PLUS loans obtained through the Federal Family Education Loan, or FFEL program. The school determines which program it offers. Both versions are cheaper than most private student loans, and fixed rates mean costs won't skyrocket in the future.

"Some families have arrangements whereby students help pay for some of the costs or pay the parents for all of the loan," says Cindy Bailey at the College Board.

3. Ask private lenders lots of questions. Don't just respond to any loan advertising campaign or recommendation, no matter who it's from. Shop around. For starters, check out rates from lenders on Bankrate's College Finance home page. And be sure thoroughly understand what you're getting into.

Here's a list of questions to start with:
Does the loan have a fixed or variable rate?
If it's variable, to what index is it tied?
How often can it change?
Can the margin change? What determines the margin amount?
Is there an interest-rate cap? If so, what is it?
What are the fees, including those to temporarily stop payments with a so-called forbearance?
How difficult is it to consolidate loans and cut interest rates after graduation?

"Don't just react to the emotional advertising. You need to dig down to the details," says Martin.

4. Scrutinize private student loan discounts. Loan perks sound enticing, but look at the details. Analysis by Project on Student Debt shows that the value of a 1 percent discount varies widely, depending on how it's applied.

For instance, a loan that lowers interest rates by 1 percentage point at the start of repayment -- that is, after interest had been accruing for four years while a student attended college -- really amounts to a 0.78 percent savings.

A 1 percent discount on principal after 48 consecutive, on-time payments computes to a minuscule 0.12 percent savings.

And a 1 percent reduction on the interest rate after 48 consecutive payments is really worth 0.33 percent.

For more on the discounts, visit the Project on Student Debt Web site.

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5. Consider paying interest ASAP. Private student loans offer three options when it comes to repayment plans: total deferment loans, interest-only, or -- the least popular option among borrowers -- a loan in which students pay off interest plus principal while they're still enrolled.

Total deferment loans let you put off paying interest until after college. That makes borrowing cheaper at first, but George Pappas, from the private lender EduCap, warns that pushing off payments can boost monthly costs by as much as 30 percent to 40 percent. Instead, he urges students to opt for interest-only loans, which they start paying immediately while in school.

Consider a student who pays interest only while in school for a $20,000 private loan that charges an 11 percent interest rate. The monthly tab will be $183. That's $6.10 a day. Once the student graduates, and owes principal, too, the monthly payment will climb to $221 a month, says Pappas.

On the other hand, with interest accruing at 11 percent, that same $20,000 loan mushrooms to more than $30,000 if a student pays nothing for four years. As a result, monthly payments -- which include interest and principal -- will be $343 after graduation, says Pappas.

"Interest upon interest is accruing while they're not making payments. That's why it's so much more and people get behind," says Pappas. "If you can make the interest payments, it's a much better choice."

Bankrate.com's corrections policy
-- Posted: Feb. 5, 2007
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