For students who must borrow, federal reform and a brightening economy are silver linings

Lauren Hoover made a classic freshman mistake. When she maxed out her low-cost federal Stafford loan and ran out of scholarship money but still hadn't paid all her first-year bills at Indiana University-Bloomington , she contacted only one lender. It gave her and her parents a private loan at 7.4 percent to bridge the gap.

It wasn't until long after the papers were signed that her mom noticed her employee credit union offered private student loans with lower interest rates. The loan from the Eli Lilly Federal Credit Union brought Hoover's cost of borrowing for her sophomore year to less than 4 percent. Hoover, who graduated early with a degree in exercise science in December 2009, is now reaping the benefits of the switch.

The lower interest rate cut her monthly payments by about $50 and will probably reduce the total amount she will pay in interest over the years by more than $6,000. Figuring out the best loan option "is so incredibly confusing," Hoover says. But the savings are so significant "it is worth the legwork."

As scholarships lag behind skyrocketing tuition, a growing number of students have no choice but to borrow to pay their college bills. Luckily, incremental improvements in the economy (like a loosening credit market), growing competition among private lenders, and federal reforms are making student loans cheaper, simpler to get, and easier to repay.

For fall 2010, federal student loans offer undergrads the chance to borrow at rates as low as 4.5 percent, affordable monthly payments, and a chance at getting some of the debt forgiven. Those who need to borrow more than the government's maximums and who have good credit ratings (or cosigners with good credit) can apply to private banks and credit unions, many of which have been cutting their interest rates on alternative student loans. But even the private companies advertising alternative tuition loans are now required to advise students to start with the federal loans, which offer many advantages. Several developments promise to make student loans of all types even more attractive. They'll be:

Cheaper.

Nearly all undergraduates can borrow at least $5,500 a year (older, low-income students as much as $18,000) at fixed annual percentage rates that in the summer of 2010 had fallen to a range of 4.5 percent to 6.8 percent. Unlike private lenders such as Sallie Mae, the federal Stafford program will lend to students without requiring a payment guarantee from an adult with good credit.

To qualify for the Stafford loan program, students must be U.S. citizens, attend school at least half time, and not be in default on other federal student loans. Some low-income students can also borrow from the federal Perkins program. The interest that students pay on federal student loans and the amount they can borrow depends on age, year in school, income, and college. People with lower incomes generally get lower interest rates. Older students can generally borrow more. And there's more good news on the horizon: For the 2011-2012 academic year, the government will slash the interest rate on Stafford loans made to low-income students to just 3.4 percent.

Those who need to borrow more than the federal maximum also have newly attractive options. Credit unions and Web entrepreneurs are rushing in to fill the vacuum created when the credit crunch wiped out many traditional student lenders. The state-owned Bank of North Dakota, for example, offers students in or from the state a variable rate that rested at 2.04 percent during the summer. By mid-2010, the easing of the credit crunch and new competition had pushed other lenders, such as Sallie Mae and the credit unions belonging to Credit Union Student Loans (www.cuStudentLoans.org), to cut their lowest variable-rate loans to about 3 percent for students with excellent credit. Of course, loans with variable rates get more expensive when interest rates rise.

Simpler to get.

The Department of Education has simplified the process of getting a federal student loan. While students still must complete a Free Application for Federal Student Aid, the government has streamlined the online version of the form. To apply for a federal loan, students need only make sure the FAFSA is filled out entirely, including the box asking about their interest in loans, and tell their college they would like a loan. They no longer need--or have the opportunity--to shop for a bank to make a federally backed loan. The law now requires colleges to funnel all federal loan applications directly to the government. "The process will be easier" for students, says Sharon Hassan, director of financial aid for Goucher College in Baltimore.

Several Web entrepreneurs promise to help students find inexpensive private loans. OvertureMarketplace.com, SimpleTuition.com, Studentchoice.org, Studentlendinganalytics.com, TuitionU.com, and cuStudentLoans.org all pledge fast Web searches for loans. And new peer-to-peer websites such as People2capital.com and Prosper.com offer lists of private investors willing to lend tuition money.

Recent reforms of federal laws protecting borrowers can also help students make the right choices in their loan hunts. Consumer protection laws that took effect in February bar banks and other private lenders from luring potential borrowers with promises of unrealistically low monthly payments. Now, lenders must warn loan applicants up front of their maximum potential monthly payments. In addition, banks must give applicants up to 30 days to consider a loan offer and three days to return the money and cancel a loan.

Easier to repay.

The federal government appears to be working out the kinks in the income-based repayment, or IBR, plan it launched in 2009. Borrowers who tried to sign up for it shortly after its launch complained of confusing instructions, incorrect bills, and red tape, says Heather Jarvis, a senior program manager for the nonprofit Equal Justice Works and an expert on student debt. Government contractors handling calls and applications sometimes improperly steered applicants to a sound-alike program called income-contingent repayment, which generally isn't as good a deal for borrowers, she says.

Applicants still have to be vigilant, but "there has been a lot of improvement recently in processing" applications, she says. Borrowers who consolidate their federal student loans with the government can sign up for income-based repayment and cap payments at 15 percent of discretionary income. People in public service jobs who make 10 years' worth of payments on time can have the remainder of their loans forgiven. Anyone who makes 25 years' worth of payments on time can have the rest of the loans forgiven, no matter what kind of job they hold. And those who take out loans after 2014 will find it even easier to repay, as the maximum monthly IBR payment is slated to drop to 10 percent of a borrower's discretionary income.

Private lenders have also started easing tough repayment requirements. During the credit crunch, many private lenders required parents to begin repayments immediately, instead of waiting until the student left college. But some credit unions are now letting parents defer payments again. And Sallie Mae says it will allow parents to make token payments of as little as $25 a month (though it may charge higher interest on those loans). In addition, Sallie Mae has cut the amount of time before cosigners can apply for release from repayment responsibility to 12 on-time payments from 24. Of course, the company will approve parental relief only if a student has developed a good credit score. Many other lenders allow parents to apply for release after 24 payments.

The changes have been a boon to the entire Hoover family. Lauren, who now markets and manages wellness programs for corporations, can afford to whittle down her loan ahead of schedule. Meanwhile, her younger brother is borrowing only from their mom's credit union for the extra cash he needs to attend Ball State University in Muncie, Ind. Clearly, big sister says, he "learned from my mistake."

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