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Be Wary of Private Student Loans

High interest rates and tough payback rules could leave your student out on a limb.

Until a year or two ago, private student loans (not to be confused with federal student loans offered through private lenders) were the hottest thing on campus since sliced pizza. The number of private loans more than tripled between 1998 and 2008, rising from 7% of all educational loans to 23%. Then credit seized up and dozens of lenders left the market. Now, the lenders who continue to offer the loans have made them more expensive and harder to obtain.

That isn't necessarily a bad thing. Unlike federal loans, which carry fixed rates and flexible repayment terms, private loans carry variable rates, which typically end up in double digits. They offer little relief for borrowers who have trouble repaying, and they let students borrow relatively high amounts, making it easy for them to get in over their head.

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Lesson? Have your student max out on federal loans first and use private loans sparingly, if at all. New rules from the Federal Reserve, which take effect in early 2010, dictate that lenders must disclose more and better information about interest rates and fees. In the meantime, here's what you should watch out for:

To cosign or not to cosign. Your student will need not only good credit but also a creditworthy cosigner -- usually a parent -- to get a private loan. Lenders look for a score of at least 680 on the part of the student (or no credit score at all), and 700 to 720 for the cosigner, says Kevin Walker, of SimpleTuition.com. If you cosign, you are on the hook if your student is late on or misses a payment.

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Study interest rates. Lenders peg the interest rate for private student loans to the prime rate or the LIBOR index, plus a margin, which depends on the applicant's and the cosigner's creditworthiness. Pay attention to the highest advertised rate, not the teaser, says Tim Ranzetta, of Student Lending Analytics, an independent research company. The average starting rate, including the margin, on private student loans has been running about 11%, he says, but variable rates tend to go up, not down. Figure the rate will rise by about four percentage points over the life of the loan.

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Compare total costs. Also vet the fees and find out when and how often interest is added to the principal, both of which affect the total cost of the loan. The annual percentage rate wraps those factors, along with the interest rate, into a single number. But keep in mind that the APR reflects the cost over the intended life of the loan, and doesn't let you compare the costs of loans with different repayment periods. Also, the APR changes depending on whether the student is in school or in repayment, so be sure to check both numbers.

Shop the lenders. Applying for too many loans over an extended period can hurt your credit score. Select the most promising four or five lenders and apply to all of them within a 30-day window. To start, ask the financial-aid office at your student's school whether it provides a list of preferred lenders. Compare lenders and loan terms at FinAid.org, SimpleTuition.com and StudentLending-Analytics.com.

Editor's note: This story originally appeared on the Web August 14, 2009.

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