How to shop for student loans

(Fortune) -- As college acceptance letters arrive this month, families will be celebrating the good news (we hope!), then bracing for the grueling process of figuring out how to pay for four years' tuition.

There is relief for some. While costs continue to soar, a dozen colleges, from Amherst to Williams, have eliminated student loans from financial-aid packages - replacing them with outright grants - and others are waiving tuition for low-income families. Harvard recently said it's capping family contributions at 10% of annual income for parents earning up to $180,000 a year.

It's a promising trend, but many families will still need to borrow. Meanwhile, the student-lending market has taken two dramatic blows in the past year. First, amid the subprime mortgage crisis, funding for all kinds of loans has dried up. At the same time the College Cost Reduction and Access Act of 2007 cut government subsidies to issuers of federal student loans, further squeezing the market.

As a result several major education lenders - including a few state agencies -have stopped making loans. "It was the perfect storm," says Mark Kantrowitz, publisher of FinAid.org. "These are challenging times to be an education lender."

What does that mean for borrowers? A few simple rules can help families navigate this tougher market.

Start federal, and shop around. With smaller fees, lower interest rates, and better terms than private student loans, federal loans are still the best option for most borrowers and remain widely available despite the credit crunch. Some are need based, but even high-income families can qualify for the unsubsidized Stafford student loan and the PLUS loan for parents.

However, this year it's more important than ever to shop around. Lenders compete by discounting rates from the maximum set by law, but many dialed back incentives after the subsidy cuts. "There are fewer deals out there, but there are still lenders offering interest rate cuts of up to 2% and partial forgiveness of origination fees," says Kalman Chany, president of financial-aid advisory firm Campus Consultants.

Don't limit yourself to the college's preferred-lender list, which may not include the companies offering the best deals. For a broad comparison of rates, go to FinAid.org, which tracks discounts by major lenders.

Check with your state. More than 30 states have programs to provide federally backed and other education loans to residents or in-state students at competitive rates. Some, including those in Michigan, Missouri, New Hampshire, and Pennsylvania, have curtailed their operations because of the credit crisis. But others are still offering discounts and other options.

For example, the Massachusetts Educational Financing Authority has a loan for parents that can be secured against your house to add the tax advantages of a home-equity loan, with a fixed interest rate that was lower than the PLUS loan's rate last year. Agencies have different mandates and offerings vary greatly, so remember to check with your home state as well as the state of the college, and visit efc.org for a list of state-based lenders.

Avoid private student loans. With lenders feeling pinched, expect a big marketing push for their higher-margin product, the private student loan. But experts agree that those loans should be a last resort because they carry high variable rates and fees.

Some families are tempted to go private because the student can be the primary borrower, with parents as co-signers. But co-signers are still responsible for the loan. If you want your child to share the burden, Robert Shireman of the Project on Student Debt recommends making a deal with Junior to help repay the PLUS loan instead.

If you do decide on a private loan, be aware that you won't always get the lender's lowest advertised rate - often you learn your rate only after you submit an application. And comparison-shopping is costly: Every application can knock up to five points off your credit score. Kantrowitz of FinAid.org recommends trying three lenders at most, including a bank, a nonbank lender, and a state agency.