Student Credit Crunch May Ease

Loan demand soars, but there are numerous glimmers of hope for getting school funding.

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Thinking about borrowing to pay for graduate school? Listen first to Bobbie Daniels, a fourth-year osteopathic medical student at the University of Medicine and Dentistry of New Jersey.

She already owes more than $200,000 in federal student loans. And because of credit card troubles, she couldn't borrow the final $7,000 she needed for her last year in medical school. "I sold all my furniture, everything but my bedroom set. I had to move out of my apartment and move in with a roommate."

[Read more: Looking to Save for Grad School? Here's How.]

Daniels also had to ask her mother for help paying off the car she needs to get to and from classes and the hospital. A combination of family generosity and personal scrimping is making it possible to finish medical school. "But it's been kind of difficult," she says.

It will probably get more difficult, at least temporarily. A surge in the number of medical students in her specialty of obstetrics and gynecology will mean tough competition for a $40,000-a-year residency. The 28-year-old figures it will be at least five years before she can start paying down her college debts. 

[Read more in the Paying for Graduate School guide.] 

The demand for graduate student loans has never been higher, as economic troubles inspire record numbers of adults to improve their employability with new skills and credentials just as alternative funding options—such as college savings, grants, and loan repayment programs—have dried up. Meanwhile, lenders, who three years ago ran ads on late-night television offering $40,000 loans to just about any student, are now rejecting loan applications from anyone who they think might have even the slightest trouble repaying.

But new federal rules, a new income-based repayment option, and tentative signs of thawing in the credit markets hold a few glimmers of hope for anyone considering—or already struggling with—graduate student loans.

Credit cleanup. The key to finding sufficient and affordable loan funding, say experienced borrowers and financial aid counselors, is for applicants to start cleaning up their credit ahead of graduate school and then try to limit their borrowing to the cheapest federal loan programs.

The federal government will not approve new student loans to anyone who has fallen more than 270 days behind on any other federal education loans. But those who have defaulted can requalify for new loans by consolidating their defaulted debts with the federal government or making at least six on-time monthly payments in a row. Those who've only had troubles with credit cards, car payments, mortgages, or even other private educational loans can generally still get at least some new federal student loans without repaying those other debts. Another way prospective students can qualify for some kinds of educational loans is to find a U.S. citizen with good credit who will cosign—committing to repay the loans if the student defaults.

Dan Thibeault, a founder of Graduate Leverage, a private company that provides loans and borrowing advice to graduate students, says many student borrowers have run into trouble because they "made terrible decisions," such as taking out private loans with variable interest rates instead of sticking with the tried-and-true federal loans. That's silly, he says, because many of the federal loans are cheap, widely available (to just about any citizen or legal resident), and can be at least partially forgiven in return for public service.

After filing a Free Application for Federal Student Aid, graduate students can ask their school's financial aid offices if they qualify for a federal Perkins loan. Those loans of up to $8,000 a year charge no interest while the student is in school and only 5 percent after graduation—a remarkable bargain for an unsecured loan, considering most home mortgages charge higher rates. Unfortunately, Perkins funds are very limited, so only the neediest students qualify. Since many colleges try to spread around their scarce Perkins funds, some qualified students may get less than the maximum.