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Paying for College: What's really going on with financial aid?

By Kim Ukura

Sun Tribune

In the last six months, newspapers and other media have reported on a potential crisis in the student loan market. Alarming headlines proclaim that students will not be able to get loans for college and families will be turned down when trying to get help. But what exactly is going on?

To date, more than 50 lenders have decided to scale back, or drop entirely out of, one of the federal government's largest student loan programs -- the Federal Family Education Loan Program (FFEL). And although there are still more than 2000 lenders that participate in the program, experts are concerned because they cannot predict how the student loan market will respond as problems in the credit market continue.

In this first of two articles, we'll try to go through how the financial aid process works, what is causing the problems in the student loan market, and what the overall outlook for the system is.

How does the financial aid process work?

The financial aid process begins once students have been accepted to a college. Their first order of business is to fill out their Free Application for Federal Student Aid (FAFSA) form. Once that information is analyzed, the college prepares a financial aid package for the student, which is based on the student's "unmet need" -- the estimated difference between what the student needs to pay for school and what the family is able to provide.

A financial aid package is a combination of financial aid: institutional aid (grants and scholarships from the college), need-based aid (grants from the federal and state government), and non-need-based aid (academic, athletic and artistic scholarships from the college, and other unsubsidized loans). Need-based aid is determined by the responses from the FAFSA form. Need-based aid includes PELL grants, Minnesota State grants and work-study awards, which will not need to be repaid by the student, and types of federal subsidized loans.

Under the FFEL program, traditional students can take out a maximum of $31,000 to cover their college costs. This money is broken down by year in school - freshman can borrow $3,500 per year; sophomores can borrow $4,500 per year; and juniors and seniors can borrow $5,500 each year. Beginning fall, 2008, undergraduate students can borrow an additional $2,000 of unsubsidized loans per year. If this amount is not enough, students and their families are forced to turn to Parent Loans for Undergraduate Students (PLUS) or private loans to make up the difference.

What is the problem with

student loan market?

Potential issues in the student loan market are tied to larger problems in the sub prime mortgage industry that began last year. For many years, mortgage companies and small banks used to manage funds by bundling up loans and then selling them as commodities and securities. Other companies purchased the loans, but often found out there were a number of bad loans in the bundles and were losing money.

"All of a sudden people were losing all kinds of money on those securities," explained Pam Engebretson, account executive for Student Loan Finance Corporation, and former director of financial aid at UMM.

"As the mortgages fell apart bankers' confidence in those securities dropped off significantly," she continued. Because student loans are another type of loan that is sold as a commodity or security, banks have also lost confidence in the student loan commodities.

"Banks and investors don't want to buy student loans anymore," Engebretson added. This leaves banks without the ability to sell their loans, which leaves them with no new capital to continue to provide more loans to students.

In addition to problems in the larger market, federal legislation that went into effect on October 2, 2007, also impacted the student loan market.

The biggest change was to guarantee a cut in student loan interest rates over the next five years, moving from 6.8 percent in 2007-08 to 3.4 percent for the 2011-12 school year.

While this is good for students, it also had an impact on the overall student loan market. In order to lower the interest rate, the federal government required banks to pay more up front for each loan they give out, and also significantly lowered the interest banks receive on their student loans.

"While there was a slim margin of profit previously on student loans," Engebretson explained, "there's now nearly no profit at all in student loans."

"I think coupling the new law with restricting the profits on student loans, and with the fallout in the mortgages and financial crisis the banks are seeing across the United States, those two things are really what's driving it right now," she added.

What does this

mean for students?

"From a consumer standpoint that you have fewer options," Engebretson said. At the same time, some of the banks that are still part of the student loan market are starting to choose which schools they will do business with.

"There will be some colleges that may have a very difficult time finding any lender to offer student loans at their school," Engebretson said.

Financial columnist Liz Pulliam Weston noted that lenders are often pulling away from schools with low graduation rates -- places like for-profit and vocational schools -- because if students don't graduate the chances of paying back their loan goes down.

Engebretson said that the biggest impact for students would probably be for families that needed to take out private, alternative loans to help pay for college.

"In the past some families have looked at second mortgages to be able to help finance higher education," Engebretson said. "Those are getting to be more difficult to come by."

However, Engebretson also noted that this is not the first time the student loan market has been impacted by larger market issues in the United States.

"I'm one of those people that always believes everything is cyclical. This is not the first time our government has ever seen a recession; this not the first time we've ever seen some dips and some fluctuations in financial markets," she said.

"I think eventually this will subside and things will calm down again, but they're probably not going to calm down, in my opinion, for about the next six to 12 months."

The second story in this series on May 28 examines Minnesota universities and colleges and how they are coping with upheaval in the economy and the financial aid industry