Sallie Mae, Wells Fargo and Discover may not have as much competition making private student loans after all.

A number of community banks are discovering that bulking up on student loans is easier said than done.

Banks are struggling to improve earnings, prompting many to expand the types of loans they make. Several smaller banks selected private student loans, an area that bigger banks largely shied away from after the financial crisis.

Many of those banks are finding out why the larger banks back off; challenges abound in areas such as servicing and compliance.

"These are very risky loans," adds Andrew Gillen, research director at Education Sector, an independent think tank. Borrowers are often debt-ridden with federal loans when they apply for private loans.

Private loans are down 72% from their peak in 2007-08, according to the College Board. Still, some banks are trying to make it work. Private loans rose 3% during the 2011-12 academic year compared to a year earlier, to $6.4 billion, according to the College Board.

Students once borrowed "whatever it took" to attend college, Gillen says. Today, students and their families are more concerned about the cost of college and are choosing cheaper options. More discretion, along with the loans' risky nature, has led to drastic declines, Gillen says.

The federal government's decision to stop guaranteeing private loans also contributed to the decline.

"The private loan market is an important supplementary source of funds" the College Board noted in a recent report. "But the loans generally have higher interest rates … and less favorable repayment provisions than federal loans."

Higher rates are enticing to some banks. Private student loans often have rates near 10%, compared to less than 7% for federal loans, Gillen says.

Student loans can also help banks diversify. Most community banks, which used to rely heavily on real estate loans, want to get away from CRE, says Steven Reider, president of Bancography. Some have pursued commercial loans; others are bulking up in mortgages, home equity or indirect loans. Student loans "may be one other venue for diversifying the loan portfolio into other non-real estate sectors," Reider says.

FMS Bank in Fort Morgan, Colo., began making private student loans a year ago to fill lending gaps, says John Sneed, the $133 million-asset bank's president and CEO. "First and foremost we try to serve the needs of customers in terms of C&I lending," he says. "We use student loans to get loan volume up."

FMS is willing to let student loans comprise up to 30% of total loans, based on demand, Sneed says. The bank uses iHELP, a program from Student Loan Finance that offers servicing, to address its inability to handle such tasks in-house.

Servicing is complicated, says Kevin Moehn, iHELP's program director. Cosigners are usually required, and the lender must work with colleges to certify enrollment and disbursements. Unlike other loans, repayment is typically delayed for years. Deferments and forbearances are common.

For those reasons, the number of banks using iHELP has more than doubled in the last year. "These loans are going to some of their best customers, who are usually upper middle income," Moehn adds.

Still, regulatory scrutiny looms, particularly from the Consumer Financial Protection Bureau. The CFPB did not respond to requests for comment.

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