A New Chapter in Student Lending?

College students may be facing a dramatically different student-loan environment next year: one in which they borrow directly from the government, while private education lenders focus on higher-cost private student loans or exit the market altogether.

The Student Aid and Fiscal Responsibility Act, passed by the House of Representatives last week, would eliminate the so-called Federal Family Education Loan Program, or FFELP, which currently handles more than two-thirds of student loans. FFELP enables private lenders such as Sallie Mae (SLM) and Citigroup (C) to extend and service federally-subsidized student loans like Stafford and PLUS loans. Instead, all lending would shift to the Federal Direct Loan Program, which as of February, had 1,620 participating schools (out of nearly 5,500), according to Mark Kantrowitz, who tracks student borrowing and is the publisher of FastWeb.com, a scholarship matching service.

A similar Senate bill is now being drafted and will be introduced in the near future, according to Bergen Kenny, a spokeswoman for Sen. Tom Harkin (D., Iowa). Kenny declined to offer specifics on the bill, but said that the House bill reflected the roadmap on education reform laid out by President Obama earlier this year and expectations are that the Senate bill will reflect that, as well.

Here’s what changes students can expect if the bill becomes law (and assuming its major provisions don’t change):

If they are not able to participate in FFELP, many private lenders will likely stop making student loans altogether, Kantrowitz says. That shouldn’t affect students’ federally-subsidized loans, but they may have fewer choices when it comes to private student loans.

Those who already have federally-subsidized student loans through a private lender, but borrow directly from the government for their remaining college years, will have to write at least two different checks a month when they start repaying their loans. “For some students, that could be more paperwork and less ease of repayment,” says Kalman Chany, the president of New York-based Campus Consultants, which provides financial aid advice. That problem could be solved by consolidating your loans, but that would increase your interest rate slightly because rates are rounded to the next one-eighth of a percentage point during consolidation. Consolidating several loans at 6.8%, for example, would result in a new loan at 6.875%.

For many students, private student loans are prohibitively expensive -- the average rate on private loans these days is around 11%, compared with 5.6% for subsidized Stafford loans (that interest rate is set to fall to 4.5% next year and 3.4% in 2011). Yet, three in five borrowers who take out private loans and not federal loans haven’t even applied for federal student aid in the first place, Kantrowitz says. The reason: The federal financial aid application process is difficult and time-consuming, “whereas, with a private loan, you hear advertising of getting a decision within three minutes or less,” he says.

If private lenders can no longer make federally-subsidized loans, they'll likely focus their marketing dollars on the private-loan market, potentially signing up customers who could have qualified for much cheaper federal loans. Don’t fall for that trap: Before you apply for a private loan, make sure you’ve exhausted all your federal-loan options, including taking the maximum subsidized and unsubsidized Stafford loans you can.

The education bill passed by the House will expand the Perkins loan program – which typically awards loans to students with exceptional financial need – from $1.5 billion to $6 billion. That means more students will be able to borrow under the program. Now, students who qualify can borrow up to $5,500 per year ($8,000 for graduate students), at an attractive 5%. Expanding the program may be good news for those students who wouldn’t have qualified under the current, stricter rules. But the new program would drop the government subsidy on interest payments. “The Perkins loan will be more available, but more costly because they’ll charge interest while you’re in school,” Chany says.

Not having to choose a lender may be a welcome time-saver for parents and students next summer. But representatives of the student-loan industry, who have been critical of the bill, say that in the long run the lack of choice may have a negative effect on customer service. “The incentive to improve services and innovate will be gone if students are no longer selecting their lender,” says Kevin Burns, the executive director of America’s Student Loan Providers, which represents education lenders.