Loan crisis goes to college

NEW YORK (CNNMoney.com) -- The credit crunch is hitting the college classroom.

When parents and students try to line up college funding this spring, they will likely be in for a nasty shock. They may still get a loan, but it will come at a price. Borrowers will have a more limited choice of lenders and find discounts for on-time payments or direct debit scarce. On top of that, they'll see higher rates and fees.

The credit crisis, which started last year with mortgages and has bled into many other areas, is now affecting student loans. Many lenders, particularly smaller companies not affiliated with banks, are finding their main source of funding for private student loans cut off as investors balk at buying securities backed by these loans. This will force some to boost interest rates on private loans by up to 1 percentage point, raise minimum credit scores to 650 and require parents to co-sign the loans, experts said.

"If lenders are not able to securitize, they are not getting the capital to make new loans," said Mark Kantrowitz, who runs FinAid.org, a college funding Website based in Cranberry Township, Pa. "It's an issue of liquidity and cost of capital."

On top of this, legislative changes enacted by Congress last year have sent some lenders fleeing from the federal student loan program. Lawmakers reduced the subsidy lenders receive for making government-backed loans.

While the interest rates on federal loans are set annually by the government, many lenders will stop waiving origination fees and cut out the discounts offered borrowers after they start repaying the loan, boosting the overall cost.

Private loan problems

With little or no profit to be made in the federal loan arena, some smaller lenders are exiting the business, while others are shifting their focus to the more lucrative private loan industry. Others, however, are curtailing even their private loan originations.

San Diego-based College Loan Corp., the eighth largest federal loan originator in 2006, recently announced it would stop making these loans as of March 1, though it will continue originating private loans. Lincoln, Neb.-based Nelnet Inc. (NNI) last month issued a statement saying it would "be more selective" in the loans it originates as it lays off 300 people, or 10 percent of its workforce. And on Tuesday, the Michigan Higher Education Student Loan Authority said it would stop making private loans, known as MI-LOAN.

"It's an area of concern, both in terms of the number of players and the cost of loans that students have to pay," said Tom Joyce, a spokesman for Reston, Va.-based Sallie Mae, the nation's largest lender formally known as SLM Corp (SLM, Fortune 500).

As college costs skyrocket, a growing number of parents and students rely on private loans to cover the gap between tuition and federal loans, which are limited to between $3,500 and $5,500 a year. Private loans made up 24% of education borrowing in 2006-07, up from 6% a decade earlier, according to the College Board, a New York City-based nonprofit higher education access group.

These loans, however, are much more expensive than their government-backed peers and will become even more so. For 2008-09, students will pay a fixed 6.0% on a subsidized federal loan, while the rates on private loans are as high as 13%, depending on the borrower's credit profile, and are inching upward, according to Kantrowitz. Rates on private loans change quarterly or annually, and two-thirds of borrowers pay the highest rate, he said.

"Most students will be able to get them, but they will have to be careful," said Sandy Baum, senior policy analyst at the College Board. "There will be an even greater risk of high interest rates and unfavorable terms."

Higher margins, more interest

While costlier for borrowers, the higher margins on private loans are attracting more lenders with the wherewithal to make these loans.

Private loans, for instance, made up 31% of Sallie Mae's $25.5 billion in originations in 2007, up from 20% five years earlier. The company, which suffered recently after a buyout by J.C. Flowers failed, is close to securing $35 billion in financing to carry it through the next school year. It plans to focus on the higher-margin private loan market.

JPMorgan Chase (JPM, Fortune 500) said the recent wave of failed auctions for investments backed by student loans won't affect its operations. The bank keeps its loans on its books so it is not affected by the securitization freeze. Like other big banks, Chase is not planning to raise its rates.

Chase is actually expanding its student loan operations because it has low defaults and puts the bank in touch with young people to whom they can pitch other products. In the fall it hired 140 people from struggling Nelnet and continues to add to the staff.

"We expect to have a healthy business this year," Kelly said.