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Student Loan Defaults Could Cost Taxpayers Dearly

The dramatic rise in student debt—and in student loan defaults—could leave the American taxpayer on the hook for hundreds of billions of dollars.

The landmark healthcare reform lawsigned by President Obama last March included a relatively little-noticed provision that overhauled the federal student loan program.

Uncle Sam and money
Uncle Sam and money

Previously, private companies made the loans, which were subsidized and guaranteed by the federal government.

Under the reforms, the government now lends the money directly to students. Bypassing the lenders saves taxpayers billions of dollars in subsidies.

“By cutting out the middleman, we’ll save American taxpayers $68 billion in the coming years—$68 billion,” said the President at the bill-signing ceremony on March 30. “That’s real money—real savings that we’ll reinvest to help improve the quality of higher education and make it more affordable.”

Instead of paying the money to the lenders, the money is going toward increased grants to students. But so far, that’s barely making a dent in the cost of college, or the need to borrow.

With the average price of attending a private, non-profit institution outstripping financial aid by more than $26,000 in 2008, the most recent U.S. Department of Education data available, federal loans—whether they are made or merely guaranteed by the government—are not enough.

Besides, the companies that made a living originating federally guaranteed student loans before the law changed have been forced to find new sources of revenue. That explains the growth of private student loans.

Sallie Mae —the largest originator of federally guaranteed student loans prior to the change—found in its annual study “How America Pays for College” that 13 percent of student borrowers used private loans to finance part of their education in 2010. That compares to eight percent in 2008.

While private loans still make up a relatively small portion of student debt—federal student loans account for 28 percent—their growth troubles Lauren Asher of the non-profit Project on Student Debt.

The College Debt Crisis - See Complete Coverage
The College Debt Crisis - See Complete Coverage

“Private loans really aren’t a form of student aid. They’re a very risky and expensive source of credit,” Ansher says.

Like other student loans, private loans cannot be discharged in bankruptcy. Many have variable interest rates that can change with little warning, and some have even fewer consumer protections than government loans.

“They’re a much more dangerous way to pay for a college education than certainly grants, which you don’t have to pay back, or federal student loans, which have lots of options for how you can pay them back,” says Asher.

Among the fastest growing private lenders are for-profit colleges, many of which have set up their own lending arms or contracted with other private lenders to keep credit-strapped students from dropping out.

The private loans offered through the institutions typically carry variable, double-digit interest rates, as compared to a federal Stafford Loan , which contains a fixed rate of between 4.5 and 6.8 percent. Like many government loans, the private loans typically accrue interest while the student is in school, but some private loans do not allow the student to pay that interest until after graduation.

But not all private loans are created equal.

Sallie Mae, which has identified private lending as one of its main growth areas now that the government has taken over the function of originating loans, offers what it calls a “Smart Option Student Loan,” which carries an interest rate as low as 2.88 percent and allows students to lower their rates by paying interest while in school. The product also allows the loan to be forgiven in the event of the student’s death or permanent disability.

“We believe we are the only national lender to provide this protection,” Sallie Mae spokeswoman Martha Holler wrote in an e-mail to CNBC.

Price of Admission: America's College Debt Crisis
Price of Admission: America's College Debt Crisis

That was true until Friday, when Wells Fargo announced that it, too, would forgive its private student loans in the case of death or permanent disability.

“We believe it is important to be responsive to events that affect these unique customers, and their ability to obtain financial independence and repay their loan,” said Kirk Bare, head of Wells Fargo Education Financial Services in a statement.

Legislation pending in Congress would require all private lenders to offer the same protection.

Wells Fargo offers private loans with variable rates as low as 3.4 percent , and the ability to reduce that rate another three-quarters of one percent if the student graduates.

Sallie Mae’s Holler also notes that unlike government loans, which are an entitlement with no credit check on the borrower, “private loans are underwritten to assess the student’s ability to repay.”

But Asher of the Project on Student Debt is concerned that the rise in private debt is further inflating the student loan bubble, especially because most borrowers have not exhausted their government loan options.

“That’s a really big concern that people are taking out very risky kinds of debt when they had safer options,” says Asher.

Even the lenders agree that private student loans should be a last resort, after college savings, grants and government loans.

Sallie Mae says it urges its borrowers to first fill out the government’s Free Application for Federal Student Aid , which determines students’ eligibility for all forms of federal student aid.

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