The Smartest Move Colleges Ever Made

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Editor's note: This article previously stated incorrectly that both the House and the Senate had passed the student loan reform bill. The Fool regrets the error.

For years, going to college has almost inevitably meant incurring large amounts of student loan debt. Yet although paying the rising costs of a college education isn't likely to get a whole lot easier anytime soon, colleges are at least making the right response to the credit crisis by making loans directly to their students.

Making the move
Traditionally, most students got loan funding from private lenders. Even federal government programs like the Federal Family Education Loan Program used banks and other lenders as conduits for the money students received.

However, during the early stages of the credit crunch, a combination of reduced federal funding and difficulties in selling student loan-backed securities caused many lenders to cut back or eliminate their participation in federal student loan programs. Among those lenders making cuts or opting out entirely were JPMorgan Chase (NYSE: JPM  ) , HSBC (NYSE: HBC  ) , and M&T Bank (NYSE: MTB  ) .

In response, the House passed a student loan reform bill last September that would shift funding away from private banks, as well as SLM (NYSE: SLM  ) , better known as Sallie Mae. Sallie Mae continues to make student loans, but it is no longer the colossus that it was before the crisis occurred -- its shares have fallen by 80% since mid-2007, at the height of the student loan financing crisis.

Now, more schools have voluntarily begun to cut out the middleman banks. Instead, they're using a different government program, the Direct Loan Program, under which colleges and students receive money directly from the Department of Education. According to the latest figures, nearly 2,200 schools lent money under the Direct Loan Program during 2009, up from about 1,550 in 2008.

Why it's smart
There are a number of reasons moving to a direct-lending model makes sense both for colleges and students. And in fact, many colleges -- especially those with large endowment funds -- would be well advised to make loans not only through federally funded programs but also directly from their own assets.

First and foremost, the move eliminates a conflict of interest that private lenders had. For most borrowers, federal loan programs offer the best combination of low interest rates and favorable repayment terms. Yet many banks, including Citigroup (NYSE: C  ) , Wells Fargo (NYSE: WFC  ) , and Bank of America (NYSE: BAC  ) , also offered private student loans to customers at the same time. Unfortunately, many private loans charge much higher interest rates to students, and without the guarantees provided by the federal government, lenders impose more onerous requirements on students to repay their loans.

In addition, though, having colleges invest part of their endowments toward making direct loans to students would serve two other valuable purposes. More loan availability would make it easier for all students to attend college, something that serves the mission of the schools and their endowment funds. Moreover, some of the largest colleges and universities have suffered huge losses lately, having invested much of their endowment funds in high-risk strategies like private equity and hedge funds. Taking some of their assets to make loans to students instead would help restore the lost confidence that many donors have in their school endowments.

What to do
Of course, from the student's perspective, having to take out any loan is never as good as saving to pay your own college expenses. By using a combination of savings strategies, including such investment vehicles as 529 plans and Coverdell Education Savings Accounts, students and their families can save for college expenses in ways that still leave open the possibility of financial aid once students reach college age.

Yet with the ever-increasing cost of a college education, loans will continue to play a major role in helping students to pay tuition and the other expenses of going to college. With the private market having failed to provide a lasting solution, schools have every incentive to make sure that direct lending creates better results.

Times aren't just tough for students trying to make ends meet. Matt Koppenheffer is asking why homeowners are idiots when it comes to underwater mortgages.

Fool contributor Dan Caplinger is immensely grateful to his parents for helping him largely avoid a student loan fiasco. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always makes smart moves.

Read/Post Comments (2) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 28, 2010, at 2:41 PM, djmon wrote:

    Poor Dan has no idea of what he is talking about in the matter of student loans...taking the private lenders out of the picture has offered nothing new but to have the gov take over another industry that the private sector could do with much less cost to all and much more efficiently.

    Poor Dan needs to do a bit of research.

    Dennis Montrella

  • Report this Comment On January 30, 2010, at 4:59 PM, BDRudolph wrote:

    Loans taken out of the DoE directly?

    Does this mean if Person A is granted a loan, Elementary School B does not get building insulation? Or is there a seperate budget category for this?


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