Federal student loans make up the overwhelming majority of outstanding student loan debt, but millions of borrowers also take out private student loans. Private education loans, also called alternative loans, are originated by private banks and credit unions, as opposed to federal education loans, which are originated by the Education Department and institutions of higher education.
Turning to a private education loan for help with climbing college costs can be awfully tempting. With an online application and the promise of a low interest rate, a private loan often looks so easy and so affordable.
How Are Federal Student Loans Different From Private Student Loans?
Federal loans have a fixed interest rate and offer a variety of borrower benefits, like forbearance, deferment, loan consolidation, student loan forgiveness and several repayment plans.
Private loans generally aren’t as flexible. And unlike federal student loans, private loans often have variable interest rates and require credit checks. So you’ll need a good credit history or a cosigner to land the low rate you saw online. If you have less-than-stellar credit, you could end up paying very high interest rates, and because rates on private loans are variable and fluctuate according to market conditions, whatever interest rate you qualify for could change. (You can see where your credit stands by viewing two of your credit scores, updated every 14 days, on Credit.com.)
The repayment terms on a private education loan vary by lender. With some lenders, repayment begins immediately. Other lenders may allow borrowers to defer loan payments while attending classes, as federal loans do.
You’re also likely to have fewer borrower protections with private loans than you do with federal loans.
Federal loans come with a range of borrower protections that are mandated in the federal Higher Education Act. For example, with federal Direct, FFEL and Perkins loans, every borrower is entitled to deferment due to economic hardship or unemployment for up to three years as long as the borrower meets eligibility requirements for these deferments. Federal loan servicers may also offer forbearance, a temporary postponement of payments, for up to 12 months at a time. Private education loan lenders are not required to offer forbearance or deferment options. Some lenders charge fees to process forbearance and deferment requests and may have shorter deferment or forbearance periods.
A private loan is an option to consider after you’ve exhausted federal lending options (most federal loans, after all, have borrowing limits below the cost of attendance, which private loans do not). When borrowing to pay for your college education, most experts recommend applying for federal loans first and private loans as a last resort, and in order to get a federal student loan, you need to fill out the Free Application for Federal Student Aid (FAFSA). To land a good deal on a private education loan, you’ll need to shop carefully. Rates and fees vary widely.
What to Ask a Private Student Loan Company
Here are some important questions to ask when shopping for a private loan:
- What are the credit qualifications? All private education loans require a credit check. Private lenders may consider your credit record, assets, debts, income, as well as your college or university and your field of study. If you have limited or flawed credit, like many students do, you may be approved for a loan at a higher interest rate or require a cosigner to qualify for a loan.
- What is the interest rate on the loan and how is the rate calculated? Interest rates on private education loans vary widely, with some lenders charging interest rates between 11% and 18%. Many private loans come with variable interest rates and may fluctuate due to market conditions. The interest rate on a private education loan is based on a market rate (PRIME or LIBOR or the 91-day Treasury bill) plus a margin. The margin amount, the number of percentage points you pay over and above the market rate, depends on your creditworthiness. If a lender considers you a higher risk, you’ll pay a higher margin and a higher interest rate on your loan. If a lender considers you a lower risk, you’ll pay a lower margin and a lower interest rate on your loan.
- Is there an origination fee? Many lenders charge origination fees on private education loans. There is no cap on origination fees, and they vary by lender, so shop carefully. A high origination fee could make a pricey private loan even more expensive.
- When do I begin making payments? Most student loans don’t need to be repaid until after you graduate. But some private loans may ask you to start making payments right away. Can you handle making loan payments while attending classes?
- What is the late fee? Many private lenders charge late fees if your payment arrives 10 or 15 days after the due date. The late fees can be as high as $15 or as much as 5% of the payment amount due. (Federal student loan servicers also charge late fees.)
- Can I defer or reduce loan payments during tough times? Hardship help varies from lender to lender, so you’ll want to ask before you borrow. Does the lender offer deferment due to economic hardship or unemployment? Does the lender offer forbearance, a temporary postponement in payments? Will you be charged a fee? How long will the forbearance period last?
- Will a private loan affect my eligibility for other forms of financial aid? It’s a good idea to have a private loan checked out by a financial aid official at your college or university. The last thing you want is for a private loan to hurt your eligibility for more affordable forms of financial aid.
Weigh your financial options carefully. Federal student loans tend to have more benefits and repayment options than private student loans. If you do want to use a private student loan, be sure to get the facts first and no matter what kind of student loan you decide to get, only borrow as much as you can reasonably expect to afford to repay.
This article has been updated. It was originally published August 24, 2010.