According to the lawsuit, which was filed last month in the U.S. District Court in Little Rock, Ark., the university “effectively pays off” the loans of students who withdraw from the institution, then demands repayment from those students under terms more onerous than those of the original federally guaranteed loans.

By canceling those students’ federal loan debt, the suit argues, the university prevents those loans from being considered in its official default rate and keeps its rate from suffering.

But “the decision to cancel the loan is for the student to make,” the lawsuit asserts, and the company has no right to interfere with the contracts students have made with their lenders.

The students who brought the lawsuit had obtained federally guaranteed loans through banks but withdrew from the university soon after enrolling. The university, which held their student loan money, should have subtracted the amounts of tuition they owed from those accounts, the lawsuit states. Instead, it says, the university sent the federal money back to the original lenders “without the knowledge or consent of the students,” then sought to collect tuition owed directly from the students.

Other for profit college companies follow similar payback policies for students who have obtained student loans and later withdraw from classes without completing them.

The university, in a written statement, said, “Regrettably, the plaintiffs in this matter have misconstrued the Higher Education Act and related regulations at issue.” It said its refund policies comply with federal student aid rules.

As the owner of a small transcription company, 42 year old Linda Giles does not have an extra $17,000 per year lying around to pay for her 20 year old son, Santwon Hines, to attend Pennsylvania State University. So the Washington, D.C., resident applied for financial aid from as many sources as she could. Their hard work paid off, as she and Hines applied for and received two need based grants for D.C. residents to attend college (one for $5,500 and the other for $1,500), a Federal Pell Grant for $2,290, a competitive based grant of $1,300 due to good grades, and a $1,500 university scholarship that Hines applied for on his own. The two found even more financial help this year with Hines, who is a sophomore, becoming a resident assistant, which resulted in about $7,180 in room and board fees being shaved off of his school costs plus an additional $450 book stipend. In total, the mother and son saved about $19,720 this school year alone.

More students will likely be seeking financial aid since 529 college savings plans have suffered losses. “The median 529 portfolio with 60% in stocks lost 25.6% in 2008,” says Joe Hurley, founder of the Pittsford, New York based financial advice site SavingforCollege.com. To make matters worse, with the unemployment rate nearing 8% and many companies cutting back workers’ salaries and hours, parents are finding that the financial aid packages their children have been awarded are no longer sufficient.

Here’s how to increase your chances of getting a better financial aid package:

- Ask for a professional Judgment review. The good news is you can appeal a financial aid decision. “If any circumstances changed to a family’s financial situation, they should ask for a professional judgment review,” says Mark Kantrowitz, publisher of FinAid.org, an online clearinghouse of financial aid information. Through that process, a school’s financial aid administrator can add to a financial aid package based on extenuating circumstances that have impacted a family’s finances since they initially applied for aid.

- Know what constitutes hardship. Loss of income is the type of change that’s most likely to lead to a financial aid adjustment. A large outlay of money such as unexpected medical expenses could also be grounds for an appeal. However, if your main reason for appealing is because your child’s 529 plan has lost money, your chances of a successful appeal are minimal, Kantrowitz says.

- Don’t haggle unnecessarily. Colleges aren’t looking to negotiate, says Kalman Chany, a New York based financial aid consultant and author of Paying for College Without Going Broke (Princeton Review; $20). If there has been no change to your financial status, the amount awarded will not change, says Palmira Wakhisi, assistant director of financial aid for Morehouse College in Atlanta.

- Seek other options. If the school’s financial aid administrator refuses your appeal, there is no other recourse, since he or she is the final authority. However, sites such as www.scholarships.com and www.fastweb.com let parents and students search for other types of funding such as scholarships. Also look into low cost federal loans such as the Perkins (www.ed.gov/programs/fpl/index.html) and Stafford loan programs (www.staffordloan.com), Chany advises.

Currently, the government distributes education funds through two sources: private lenders and its own in house program. Each school decides which of the options to make available to its students. Financial companies have been big beneficiaries of the system, collecting huge fees from the government; in the last school year private student lenders handed out nearly 80% of the $65 billion in federal funds. By lending directly to college bound students, the U.S. figures it can save $94 billion over the next decade and reroute the extra money to needy student borrowers. “The proposal allows us to focus on what we do best, acquire capital for loans and that saves taxpayers money,” says Robert Shireman, a senior adviser in the Administration.

This change, which could take effect in 2010 if Congress gives the O.K., would be a major blow to student lenders. Private label loans those without the backing of the U.S. have already dried up amid the credit crunch. This new proposal, part of the President’s budget, threatens the core of lenders’ profits. Student lending giant Sallie Mae, the nation’s biggest private player, disbursed $19 billion in federal loans last year, roughly 70% of its total volume. That’s why the industry is gearing up for a fight. “We believe there are alternative ways to reach the President’s education goals,” says Sallie Mae spokeswoman Martha Holler. Says Michael Reardon, a student lending executive at Citi: “Schools and borrowers will not enjoy the many critical benefits without private sector involvement.”

Analysts say the industry’s arguments may not carry much sway. Lenders insist that they provide valuable services, including running financial literacy programs that help students budget payments. But the default rate for federal student loans made by private lenders is 7.3%, compared with 5.3% for direct federal loans, according to the Education Dept. Critics contend that the program is simply a freebie for private lenders. “This is the last vestige of Soviet style capitalism,” says Barmak Nassirian, a director at the American Association of Collegiate Registrars & Admissions Officers, an education nonprofit.

Already, private lenders are feeling the pinch as more schools decide they don’t need the middlemen. The trend gained steam after New York Attorney General Andrew Cuomo investigated the cozy relationship between private lenders and financial aid officers a couple of years ago. Since the credit crisis, it has only accelerated. Some 1,624 colleges and universities now bypass the private lenders and go straight to the government for money, including Pennsylvania State University, Northeastern University, and Indiana University. That’s up from 1,075 last year.

Michigan State University made the switch in the fall. After several lenders exited the industry, harried parents started calling the financial aid office, worried that their children wouldn’t get the necessary money. To assuage those fears, the school opted to deal directly with the government’s direct loan program instead of working with private lenders. “Our students have peace of mind that they will get their loans,” says Val Meyers, associate director of financial aid at Michigan State. “We haven’t had any complaints.”