There are two types of loans that students use to pay for higher education: federal loans and private loans. Federal loans come directly from the U.S. Department of Education. Private loans are different in that they are given to a student by a state agency, school, bank, credit union, private company, or individual. Before turning to private loans, be sure to exhaust all your other financial aid options.
Which type of student loan is better?
Federal loans have lower interest rates and more flexible payment options. By filling out the FAFSA, you are automatically considered for federal student loans, and you will likely receive generous federal offers if your family meets eligibility requirements. It makes the most sense to exhaust your federal loan options before turning to the private sector. Federal loans from the U.S. Department of Education are better protected and are eligible for loan forgiveness programs, while private loans aren’t usually eligible for forgiveness or direct consolidation.
If I do need to take out a private loan, what should I know upfront?
The smartest way to take out a loan is to take out no more than you will need for school. You can always apply for more loans if it turns out you need more money later on. But, if you borrowed too much at the beginning, you are still stuck paying back the entire sum with interest.
Where do private loans come from?
- Private loans are given to a student by a state agency, school, bank, credit union, private company, or individual. Most private loans come from banks and credit unions. If you have an established relationship with a bank (e.g., your accounts are with them, your credit cards are managed by them, your parents use them for their mortgage), reach out to them before visiting a new institution.
- Websites such as Prosper and Lending Club remove the bank and instead allow you to receive loans from other people. These people are investing in your education, and your loans will have to be repaid with interest.
What do I need to know about interest rates? Are there different types of interest?
Private loans typically have higher interest rates than federal loans, so again, it makes sense to max out your federal loan options before considering a private loan. If you do take out a private loan, only borrow the smallest amount that you need for school. Just because you are approved for a larger loan doesn’t mean that you have to take out the maximum amount. The higher the loan, the more you end up paying in interest.
There are two types of interest: variable and fixed. Fixed interest is based solely on a borrower’s credit history; the higher your credit score, the lower your interest rate. Fixed rates can exceed variable rates but do not change over time. Variable rates are based on either the London Interbank Offered Rate or the Prime Rate, both of which fluctuate over time. Variable rates may be better if you know that you will be able to pay back your loans in a short amount of time. When shopping for loans, be certain that the advertised interest rates are real, not marked “as low as” or hiding fees. A 3 to 4% fee is the same as a 1% increase in interest. Those fees add up.
Tell me more about variable interest rates. Is the LIBOR or the Prime Rate better?
There are two kinds of variable interest:
- London Interbank Offered Rate (LIBOR): As of November 2018, the LIBOR rate was hovering between 2.35%–3.13% depending on the length of the loan. This rate represents the average rate that the leading banks of London would be charged if they were to borrow money from another bank for a short period of time. LIBOR is the primary benchmark for short-term interest rates worldwide. Student loan rates are usually based on a one- or three-month LIBOR average.
- Prime Rate: This interest rate is given to the highest quality lenders; it is currently about 5.25%. It represents the best student loan interest rate, which is only available to borrowers and cosigners with great credit. Generally Prime borrowers have FICO scores (credit scores) over 620, but payment history, prior bankruptcy, and other factors are also considered.
Typically, the LIBOR rate is preferable to the Prime rate. If the difference in interest rates between similar loans is greater than 0.25%, however, it is advisable to go with the cheaper one. The interest rate is unlikely to change that significantly in the long term.
For more information about LIBOR and Prime interest rates, visit FinAid.org, which offers advice for borrowers.
What should I discuss with my lender before I take out a private loan?
- Cosigners: A young student usually needs a cosigner to receive a private loan. An ideal cosigner is someone with a credit score above 680, a low debt-to-income ratio, and multiple years of established credit. A cosigner is vouching that you will repay your loan, otherwise he or she will be liable.
- Repayment: Many private loans require you to begin repayment immediately, while you are still in school. Not only that, but if you find yourself flush with cash for some reason and want to pay off your loans a little bit early, you could be penalized.
- Responsibility for interest: Unlike some federal loans for which the government will pay interest while you are in school, no one but you will pay interest on your private loan. You may be required to begin repayment on the loan and its interest while you are still in school.
- Direct consolidation: You cannot consolidate private loans into a Direct Consolidation Loan with other federal loans. There are options to consolidate and refinance private loans, but they cannot be lumped in with the federal loans you may have.
- Forbearance and deferment: It is at the discretion of the lender whether to offer forbearance and deferment options. Additionally, these loans aren’t usually eligible for loan forgiveness programs.
- Solicitation: If you receive any mail or phone solicitation about student loans, these are private loans. The U.S. Department of Education does not advertise. Do not give out your social security number over the phone. Always ensure that you are working with a legitimate lender before disclosing personal information.
What happens if I can’t pay back my loan?
Repaying loans can be tricky, especially if you find yourself without a source of income or in another unpredictable situation in which the amount you owe is more than you can afford. There are several options to consider if you are having trouble making payments on your loans for any reason. You need to act quickly to avoid the long-lasting negative consequences of missed payments.
The first thing you want to do is contact your loan servicer and request to refinance your loan. This involves switching to a different payment plan to extend the life of the loan and reduce monthly payments. If that is not an option or does not provide enough financial relief, you should request either a deferment or forbearance. Not all loans are eligible for deferment and forbearance.
- A deferment is a period of time during which you temporarily delay the repayment of the loan, typically for up to three years.
- Forbearance allows you to stop making or to reduce the amount of monthly payments on a loan for up to 12 months.
If you miss a payment, your loan immediately becomes delinquent. After 90 days of missed payments, you will be reported to the credit bureaus, and your credit score will plummet. After 270 days of missed payments, your loan will enter default. At this point, the collection agencies will come calling, you could face legal repercussions, and your credit score will suffer even more. You want to avoid this at all costs!
In short, if making your monthly loan payment becomes difficult or impossible, talk to your lender about your deferment or forbearance options well before your loan enters default. Learn more about deferment and forbearance here. If you’re interested in what happens when you enter default, click here.
Page last updated: 11/2018