Competition is slashing the cost of federal student loans. Upfront fees are coming down, and borrowers can find special deals on interest rates.

What sparked this change was the federal government's direct loan program, introduced in 1994. It forced the private lenders to improve. Now some of the private lenders are giving the government program a run for its money.

For fiscal 1999, the guaranteed student loan program is providing $32 billion to 8.7 million students. You borrow amounts prescribed by law (up to $23,000 for young undergraduates, more for graduate school).

A federal formula determines whether you have financial need. If so, the government pays the loan interest while you're in school. If not, you pay.

Today's official price structure calls for 4 percent in upfront fees--a 3 percent origination fee, to offset some of the government's costs, and a 1 percent loan insurance fee, to cover potential defaults. Interest rates, which change every July 1, currently stand at 6.92 percent for the majority of student borrowers.

Traditionally, loans were offered solely through private or state-linked lenders (about 4,100 of them today) and administered by special guaranty agencies.

The business is virtually risk-free. Congress sets the fees and interest rates that students pay. Lenders receive subsidies, to assure them a reasonable return. If a student defaults, the Treasury covers 98 percent of the loss.

For years, this system rattled on inefficiently, driving schools and students nuts. All of the lenders had different application forms and worked with the guaranty agencies in different ways. Some gave good service; others didn't. Schools complained that the money didn't always arrive by the day tuition had to be paid.

Almost nobody was competing on price. Every time Congress proposed a cut in student costs, the lenders screamed that they couldn't manage on a nickel less.

The direct loan program smashed this comfortable cartel. It let students borrow directly from the Treasury, through colleges' student aid offices.

That cut out the banks and other middlemen, at a potential savings of many billions of dollars in taxpayer subsidies. It also created a faster, simpler payment system that left most of the private lenders in the dust. So far, about one-third of the schools have joined the plan.

At first, the private lenders lobbied to snuff the program. When they failed, they entered prayer mode--hoping the Education Department would make a royal mess of things. When the direct loan program succeeded, the lenders took a radical step. They decided to compete.

First, they cleaned up their act--becoming more efficient, improving their electronic systems and addressing the schools' complaints.

"There has been more improvement in the student loan program in the last three to five years than there was in the previous 15," says William Hiss, vice president for administrative services at Bates College in Lewiston, Maine.

Next, they cut their price. For example:

* Most of the guaranty agencies now waive the 1 percent loan insurance fee.

* A few state-linked lenders are slashing effective interest rates for state residents or students attending in-state schools. In Vermont, the Student Assistance Corp. provides an annual rebate to borrowers equal to 1 percent of their principal balance. The Iowa Student Loan Liquidity Corp. and Wyoming Student Loan Corp. don't charge their borrowers the 3 percent origination fee.

* National lenders are reducing upfront costs to increase their market shares. PNC Bank chopped 1 percentage point from the origination fee. Citibank did the same, and it waives the 1 percent insurance charge. Large numbers of lenders offer fat interest-rate discounts to borrowers who repay electronically and on time.

* To stay in the game, the direct loan program will cut 1 percentage point from its borrowers' upfront costs, effective today. It also announced small interest-rate cuts for electronic payments and for graduating students who gather their various borrowings into a single loan.

The government's price cuts brought the private lenders back to the barricades. Now they're trying to kill direct loans again.

With loan programs in flux, the schools should try to work with them all, rather than stay exclusively in (or out) of the federal plan. Students should check their options to get the price cuts while they last.

Direct lending proved that there's value to having two, competing loan-delivery systems--especially when the taxpayers can save money too. If Congress interferes with the government's success, you might not have it this good again.