Student Credit Crunch May Ease

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.

The next-best deal is a federal "subsidized" Stafford loan. Students whose expected contribution is less than the cost of their schooling can get loans of up to $8,500 a year that charge no interest while the student is in school and 6.8 percent after graduation. For the 2010–11 academic year, no lender is supposed to charge an additional fee of more than 1 percent. Many lenders waive at least part of those fees.

Any graduate student, no matter how far behind in utility payments or other nonfederal loans, can borrow up to $20,500 a year through the government's "unsubsidized" Stafford program. Those loans charge 6.8 percent interest and up to 1 percent in upfront fees for the 2010–11 academic year. Although no payments are due while the student is in school, the interest does accrue. The government will cut off most graduate students from any new Stafford loans after they've borrowed $138,500 from the program. Medical students have a higher total Stafford limit of $224,000.

Other options. Those who need more than Stafford loans have borrowing options, but they are more expensive and harder to get. Federal Grad PLUS loans, for example, can cover the full cost of attendance (after other aid is subtracted) at an interest rate that is capped at 8.5 percent and with fees of no more than 4 percent of the value of the loan, for a total annual percentage rate of 9.4 percent. (Some lenders charge less. Students who borrow their PLUS loans directly from the federal government, for example, can pay as low as 7.65 percent annual interest and fees of just 2.5 percent, for an APR of a little more than 8.2 percent.)

But the government won't issue Grad PLUS loans to anyone with bad credit, unless the applicant can find a U.S. citizen with good credit willing to cosign.

While all students should avoid overborrowing, Thibeault warns medical and law students, especially, against underborrowing. Avoiding federal student loans can backfire if students have to use credit cards or private loans to tide them over after graduation for residency or exam studies. "Some of the teaser rates on the private loans might start low, but they will probably rise. And it is better to borrow at 8.5 percent than 13," he says. Thibeault recommends that students in their final months of graduate school prepare a budget for the coming year. If it looks as if they'll need extra cash, they should apply for the maximum federal student loans available, which can be disbursed only while a student is enrolled in school. Those who end up not needing the money can repay it quickly, since there is no prepayment penalty for federal loans.

Another big advantage of the federal loans: They now offer a new income-based repayment option that allows students to cap their payments below 15 percent of their incomes. What's more, those who sign up with IBR may have some of their loans forgiven after 10 years of public service or after 25 years of persistently low incomes.

The credit crunch of 2008–09 wiped out almost all other borrowing options for those who didn't qualify for federal loans, such as foreign students. But recent improvements in the economy have encouraged a few lenders and schools to start up some small and attractive alternative loan programs. A handful of highly ranked graduate business schools, including those at Cornell University, Northwestern University, the University of Chicago, and the University of Rochester, are offering private loans to international students who don't have American cosigners. Some smaller lenders, such as credit unions and some nonprofit state agencies, are offering alternative education loans at fixed rates as low as 7.7 percent.

As difficult and confusing as arranging graduate loans can be, paying them off can be even more of a challenge.

Economic troubles have hampered many programs that had promised to pay off students' loans for them. Kentucky, for example, has cut back on student loan payments it had promised to some teachers. Similar programs for public serv­ants, including nurses and soldiers, have been suspended in California, New Hampshire, and Pennsylvania. The Missouri Higher Education Loan Authority has suspended its offer of deeply discounted interest rates to public servants.

And economic realities should tamp any optimism that even the ritziest graduate degree will yield a high-paying job that will make paying off big loans easy. Mass layoffs of attorneys across the country are causing worries among law students and newly minted lawyers. Although graduates of top-flight M.B.A. programs typically repay their loans within nine years, they, too, need to be realistic.

"Students need to consider what is their earning potential when they graduate," says Jack Edwards, director of financial aid for Stanford's Graduate School of Business. A recent study of graduates of the University of Chicago Booth School of Business found that their average starting salary was a healthy $126,000, and, within nine years, the men were earning an average of $400,000. In the same period, the women's salaries averaged $250,000. And 13 percent of women had stopped working altogether, often because of family responsibilities.

Bobbie Daniels, the medical student, says she is counting on an eventual salary in excess of $200,000 to help her pay down her big debts. Borrowing so much is not ideal, she says. "Live as frugally as you can starting out. You can't get that money back," she says. And fix any credit problems before enrolling in graduate school, she advises.

But small financial worries shouldn't stop anyone from pursuing a dream education, she adds. "I don't want to discourage people. I am very happy I will be a doctor. If you can afford to do it, you should."