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Direct Loans vs. the FFEL Program

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Federal education loans are available either through the William
D. Ford Federal Direct Loan Program (“Direct Loans”) or the Federal
Family Education Loan Program (“FFEL Program” or “FFELP”). The FFEL
Program is sometimes referred to as the federally-guaranteed student
loan program.

The choice of loan program available to a borrower depends on the
college. About three quarters of colleges participated in FFELP and
one quarter participated in Direct Loans in FY2008. But about a third
of the Direct Loan colleges also participate in FFELP to maximize
borrower choice. Borrowers have a choice of lenders in the FFEL program
but not in the Direct Loan program.

Both programs offer Stafford, PLUS and Consolidation loans, but there
are some differences.

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Differences between Direct Loans and FFELP

The following discussion summarizes the main differences from a
borrower perspective:

  • Source of Funds. In the FFEL program the funds for the
    loans come from banks and other financial institutions. In the Direct
    Loan program the funds for the loans come directly from the US
    Department of Education, which in turn gets the funds from the US
    Treasury.

    (During the credit crisis many lenders, especially non-bank
    lenders and state loan agencies, are borrowing funds from the US
    Department of Education in order to continue making new loans. These
    lenders previously obtained funding from investors, but were unable to
    raise funds from the capital markets because of the credit
    crisis. Many banks, on the other hand, can rely on customer deposits
    as a source of funds and so are not as dependent on the US Department of
    Education for funding to continue making federal education loans. More
    than two-thirds (68%) of FFELP loan volume was funded in part by the
    US Department of Education in FY2008; almost one-third (32%) was not.)

    Overall, though, the source of funds does not matter much from a
    borrower’s perspective. Money is fungible; it is green regardless of
    whether it comes from the federal government or a financial
    institution.

  • Consolidation Loans. Because the Ensuring Continued
    Access to Student Loans Act of 2008 (ECASLA) only addressed funding
    problems in the Stafford and PLUS loan programs, consolidation loans
    originated since October 1, 2007 are unprofitable to the FFEL program
    lenders. As a result, most FFEL program lenders have stopped offering
    consolidation loans. Consolidation loans remain available from the
    Direct Loan program at
    loanconsolidation.ed.gov.
    Borrowers in the FFEL program may consolidate their loans into the
    Direct Loan program.

  • Interest Rates. Congress sets the maximum interest rates
    in both the FFEL and Direct Loan programs. The interest rate on the
    Stafford Loan is identical in both programs. The interest rate on the
    PLUS loan, however, is 8.5% in the FFEL program and 7.9% in the Direct
    Loan program. The Higher Education Reconciliation Act of 2005
    increased the interest rate in the FFEL program from 7.9% to 8.5%
    effective July 1, 2006 but did not implement a similar increase in the
    Direct Loan program.

  • PLUS Loan Approvals. There may be differences in the
    PLUS loan approval rates in the two programs, with parents more likely
    to obtain a PLUS loan approval in the Direct Loan program. Analysis of
    the 2007-08 National Postsecondary Student Aid Study (NPSAS) suggests
    that the Parent PLUS loan denial rate in the FFEL program was 42% in
    2007-08, double the 21% Parent PLUS loan denial rate in the Direct
    Loan program.

    The PLUS loan program requires the borrower to not have an adverse
    credit history, as specified in Section 428B(a)(1)(A) of the Higher
    Education Act of 1965. The regulations at 34 CFR 682.201(c)(2) define
    an adverse credit history for the FFEL program as having had a default
    determination, bankruptcy discharge, foreclosure, repossession, tax
    lien or wage garnishment in the last five years or a current
    delinquency of 90 or more days. A similar definition appears in the
    regulations for the Direct Loan program at 34 CFR
    685.200(c)(1)(vii). However, the FFEL program regulations at 34 CFR
    682.201(c)(2)(iii) specifically permit lenders to establish “more
    restrictive credit standards” for the PLUS loan. At least one large
    FFEL program lender misinterprets the 90-day delinquency requirement
    as involving a five-year lookback instead of looking just for current
    delinquencies. But since FFEL lenders are permitted to adopt more
    stringent credit underwriting criteria, this error is technically
    permitted by the regulations. This tougher standard for an adverse
    credit history has a significant impact on PLUS loan denial
    rates. Some FFEL program lenders may also have implemented a debt to
    income ratio standard for PLUS loan approvals.

    From 1994-95 to 2005-06, Parent PLUS loan volume in the Direct Loan program
    represented 12.6% of non-consolidation loan volume, compared with
    11.0% in the FFEL program. Parent PLUS loan borrowers represented 9.1%
    of unduplicated borrowers in the Direct Loan program and 8.0% in the
    FFEL program. This suggests that Parent PLUS loan borrowers are 12.1%
    (loan volume) to 12.5% (unduplicated borrowers) less likely to get a
    Parent PLUS loan in the FFEL program than in the Direct Loan program.
    (Data from 2006-07 onward was excluded to avoid the impact of the
    different interest rates in the two programs and the introduction of
    the Grad PLUS loan.) The program-specific marketshare for the Parent
    PLUS loan has been growing steadily since it was about equal in
    1996-97, but it has been growing faster in the Direct Loan program.

  • Repayment Plans. Both Direct Loans and FFELP offer
    standard repayment, extended repayment and graduated repayment.
    Income-contingent repayment is available only in
    the Direct Loan program and income-sensitive
    repayment
    is available only in the FFEL program. A new repayment
    plan, income-based repayment, is available in
    both the FFEL and Direct Loan programs starting July 1,
    2009. Income-based repayment usually yields a lower monthly payment than
    either the income-contingent or income-sensitive repayment plans.

    FFEL program lenders are required to allow borrowers to change
    repayment plans at least once a year. Some permit more frequent
    changes. The Direct Loan program allows borrowers to change repayment
    plans at any time.

  • Loan Forgiveness. Public
    Service Loan Forgiveness
    is available only in the Direct Loan
    program. However, FFEL program borrowers may obtain public service
    loan forgiveness by consolidating their loans into the Direct Loan
    program.

  • Loan Discounts. The FFEL program previously offered
    better front-end and back-end discounts than the Direct Loan
    program. Front-end discounts include fee waivers and graduation fee
    rebates. Back-end discounts include prompt payment discounts and
    auto-debit discounts. The credit crisis and cuts to lender subsidies
    caused most lenders to cut their discounts. Also, any lender that
    intends to sell its loans to the US Department of Education cannot
    offer better back-end discounts than those offered by the US
    Department of Education, namely a 0.25% interest rate reduction for
    having monthly payments automatically deducted from your bank
    account. So while some lenders may still offer better front-end
    discounts, none offer better back-end discounts.

    Because of all the conditions on loan discounts in both programs,
    the overall value of the discounts was more apparent than real. While
    some individual borrowers might benefit, the majority of borrowers do
    not realize significant savings.

  • Customer Service. The competition between the Direct
    Loan and FFEL programs has been healthy for both programs, leading to
    improved quality of customer service.

    The origination of new loans in the Direct Loan program is streamlined
    from a borrower perspective, since the colleges handle most of the
    administrative overhead as part of the financial aid awarding process,
    using the same disbursement system as the Pell Grant program. Although
    the FFEL program lenders also provide common loan certification and
    disbursement systems to streamline the loan origination process, this
    isn’t quite the “one-stop shop” provided by the colleges’
    administration of the Direct Loan program. This yields a slight edge
    to the Direct Loan program in borrower satisfaction with the loan
    origination process.

    However, the advantage shifts to the FFEL program when the loans enter
    repayment. Borrowers complain about both programs in roughly equal
    numbers, but since FFEL handles three times the volume of the Direct
    Loan program, that suggests that there is somewhat better quality of
    customer service in the FFEL program after the loans enter repayment.

  • Preventing Defaults. The FFEL program does a slightly
    better job in preventing long-term loan defaults than the Direct Loan
    program, partly because of the default aversion role of state
    guarantee agencies and partly because FFEL lenders are more aggressive
    in presenting delinquent borrowers with deferment, forbearance and
    extended repayment options. The FFEL lenders offer better default
    aversion tools and borrower counseling. On a long-term basis borrowers
    in the FFEL program are about one-fifth less likely to default, but
    this is mostly due to a much lower long-term default rate on
    consolidation loans. When consolidation loans are excluded, the
    long-term default rates are much closer, with borrowers about 5% less
    likely to default in FFEL. While the US Department of Education claims
    a lower short-term default rate
    than the FFEL program for the FY2007 cohort, this is mostly due to the
    different mix of schools in the two programs, the restriction of
    income-contingent repayment to the Direct Loan program and a recent sharp
    increase in deferment and forbearance rates in the Direct Loan
    program.

  • Potential Change in Holder. Previously, some FFEL
    program lenders would sell their loans to another FFEL program lender,
    often shortly after origination. This does not generally occur very
    much these days, due to the very tight margins on these loans.
    However, about two-thirds of the FFEL program loan volume in 2008-09
    was funded through the Ensuring Continued Access to Student Loans Act
    of 2008 and has been or will be sold to the US Department of
    Education. This is in contrast with the Direct Loan program, where
    federal education loans are held by the US Department of Education for
    the life of the loan and are not sold. The main practical impact on
    borrowers when a loan is sold is the potential for a change in the
    servicer on the loan, which would mean a different mailing address for
    monthly payments.

  • Outreach. The FFEL program does a better job of
    providing financial aid outreach to students in secondary schools and
    offers debt management and financial literacy workshops to college
    students. Such activities are part of the mission of the state
    loan guarantee agencies.

  • Other Products. Some FFEL program lenders offer other
    products and services, such as private (alternative) student loan
    programs and college savings programs, while the Direct Loan program
    does not. Some borrowers find these options helpful, but they can also
    be a source of confusion for borrowers who may not realize that the
    same private lenders offer both federal and private student loans.

College Preferences

Colleges that participate in the Direct Loan program and colleges that
participate in the FFEL program are both extremely passionate about
the respective programs.

Until the credit crisis there was a steady shift in marketshare from
the Direct Loan program to the FFEL program. Most of the growth in
loan volume occurred in the FFEL program while volume in the Direct
Loan program remained flat to slightly decreasing. The credit crisis
reversed this trend, with loan volume increasing by 40% in the Direct
Loan program in FY2008 compared with a 12% increase in the FFEL
program. (Overall loan volume increased 17% in FY2008 compared with a
7% increase in FY2007, mostly due to the increase in unsubsidized
Stafford loan limits on July 1, 2008.) Nevertheless, volume in the FFEL
program still exceeds the volume in the Direct Loan program by a factor of
more than 3 to 1.

From a college perspective the customer service provided to the
colleges is somewhat better from some (but not all) FFEL program
lenders than the Direct Loan program. Using FFEL program lenders
avoids the difficulties associated with post-disbursement changes and
record reconciliation in the Direct Loan program, and there are better
reporting capabilities available from FFEL program lenders. On the
other hand, Direct Loans can be simpler to administer since the
college has to deal with only one lender, the federal government, and
the college’s cash flow may be smoother. The process for returning
Title IV funds is easier in the Direct Loan program since the college
can net out any changes instead of having to return funds individually
to each lender.

The use of the same Common Origination and Disbursement (COD) system
that is used for the Pell Grant program makes the transition into the
Direct Loan program relatively easy from a college perspective. The US
Department of Education has also cut the bureaucracy associated with
transitions into the Direct Loan program from months to days.

Which Program Costs Less?

There is an ongoing debate over which program costs the federal
government less. A decade ago the FFEL program was clearly more
expensive. But since then Congress has cut the lender subsidies
several times, redirecting most of the savings to increases in federal
student aid. This has made the FFEL program much less expensive to the
federal government. The most recent cuts, in the College Cost
Reduction and Access Act of 2007, when combined with the savings from
the Ensuring Continued Access to Student Loans Act of 2008 (ECASLA),
caused the FFEL program to cost less than the Direct Loan program in
FY2008 on a per-dollar-lent basis even when certain types of high-risk
consolidation loans are excluded from the analysis. On the other hand,
the Direct Loan program is projected to be less expensive in
FY2009. Which program is ultimately less expensive depends heavily on
the economic assumptions one uses in a model of the program costs.

President Obama has proposed eliminating the FFEL program starting in
2010-11, in which case all loans would be funded by the Direct Loan
program. He argues that this will save billions of dollars a year by
eliminating the middleman. Most of the savings, however, is due to the
federal government’s lower cost of funds and to a cost comparison with
a baseline that assumes that the ECASLA liquidity facilities will not
be extended. Some of the FFEL program lenders have countered with
proposals that would make ECASLA permanent and which yield at least
three-quarters of the savings from President Obama’s proposals, not
counting any savings from FFELP lenders corporate income tax revenue
to the federal government. (There is some disagreement between the
non-bank FFEL program lenders and some of the banks on the manner in
which ECASLA should be made permanent. This has to do with the
self-terminating aspects of ECASLA, where lenders with a lower cost of
funds are not currently required to rely on the US Department of Education’s
ECASLA financing. Requiring them to use federal financing for the
federal loans would increase the savings to the federal government
while decreasing the lender’s profitability.)

The lenders also argue that their proposal avoids the potential delays
and disruption associated with a transition to Direct Loans and also
avoids the need for thousands of layoffs industry-wide. The transition
risk is associated mostly with the prospect of quadrupling of
origination volume in the Direct Loan program and not with the volume
of loans entering repayment. Since loans enter repayment as students
graduate, the number of new borrowers entering repayment in the Direct
Loan program will increase more gradually. That gives the US
Department of Education more time for hiring and training servicing
staff. The Obama administration has also proposed contracting with
some of the larger FFEL program lenders to service the Direct Loan
program loans to mitigate this risk. Even so, maintaining a bit of
redundancy will help avoid future disruptions caused by a single point
of failure.

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