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Every college and university has an outside scholarship policy that specifies what happens to your need-based financial aid package when you win a merit scholarship. An outside scholarship is any scholarship not awarded by the government or the school, such as a scholarship provided by a private sector company, philanthropist or foundation.

Outside scholarships are considered resources, meaning that they reduce your financial aid package dollar for dollar. The schools often do not have a choice in the matter. Federal rules concerning "overaward situations" require the school to reduce the financial aid package when the sum of financial aid from all sources exceeds the school's cost of education by more than $300.

You are required to report any outside scholarships to the school's financial aid office. If you fail to report an outside scholarship, you may be required to repay the school or the government all or part of your need-based financial aid package.

The school's outside scholarship policy dictates how the outside scholarship is used to reduce the financial aid package. Most schools have favorable policies that first apply the outside scholarship to unmet need, and then reduce self-help (loans and work-study) before touching institutional grants. This lets you replace your loans, which must be repaid, with the outside scholarship. Some schools shelter the first $500 or $1,000 or $2,500 of outside scholarships, applying it toward self-help, and then use the remainder to either reduce gift aid and self help equally (50%) or reduce gift aid dollar for dollar (100%). (Some schools shelter as much as $6,000, but $500, $1,000 and $2,500 are most common thresholds. Other percentages applied to outside scholarships to reduce grants include 33% and 40%.) Some schools treat renewal awards more harshly than first-time awards and one-time awards, applying them first to gift aid.

Even if the school reduces grants before loans, you can still benefit from winning an outside scholarship. If you win more scholarships than you have need-based grants, the school will be forced to reduce your loans. Moreover, most schools will use the outside scholarship to reduce your loans before allowing it to affect federal and state grants. Winning a scholarship is also an honor that can add a line to your resume. Some schools will provide other benefits to scholarship winners, such as giving you priority in selecting a dorm room or working as a research assistant to coveted faculty.

Sometimes, when you are bringing in a lot of outside scholarship money, you can negotiate with the school to modify the application of their outside scholarship policy. You won't be able to get the school to increase your financial aid package, but you might be able to get them to reduce loans before grants. After all, it is in the school's best interest to encourage you to win outside scholarships. In fact, some schools have outside scholarships that are designed to provide students with an incentive to win outside scholarships (e.g., increase the student stipend by 10% of the outside fellowship amount for graduate students who win prestigious fellowships).

Many schools will work with the family to reduce the impact of the outside scholarship policy if the family is up front about reporting any outside scholarships. Besides applying the outside scholarships to self help and gapping first, they may adjust cost-of-attendance to shelter some of the scholarship. For example, although many schools will not normally adjust cost of attendance to include the cost of a computer, art supplies, or cold weather gear, they might factor in these costs when needed to allow you to keep your outside scholarship.

If your outside scholarships will result in an overaward, consider asking the sponsor to defer all or part of the award to a future year to allow it to offset a future year's loans.