is a private loan ever better?

Deciding Between Federal and Private Student Loans

Michael Lux Blog 0 Comments

To the average college student, the difference between a federal student loan and a private student loan may seem insignificant.  To a borrower trying to repay their student loans, the differences between federal and private loans are critical.

Borrowers who take a few minutes to understand the key differences between these two loan types can potentially save thousands in repayment and avoid regrettable mistakes that could haunt them for decades.

The Basics: Federal vs. Private Student Loans

Federal student loans are issued by the government according to terms set by Congress.  The Master Promissory Note (MPN) is the contract signed by students the sets out the loan terms and requirements.  Signing a Master Promissory Note is required to get any federal student loan.  However, once signed, students usually will not be required to sign a second MPN.  The MPN explains the different repayment options available on federal student loans and the various ways that federal student loans can be forgiven.

Private student loans are governed by the contract signed between the borrower and the lender, usually a bank.  The terms of these agreements can vary greatly from one lender to the next.  Some loan contracts have excellent terms that are very favorable to the borrower, while others have terms that make borrowers cringe.

Generally speaking, it is recommended that students select federal student loans if financial assistance is required.  However, private loans can be a better option in very specific, limited circumstances.

Federal student loans are preferred mainly due to their favorable repayment plans and forgiveness options.

Federal Repayment Plans vs. Private Repayment Plans

The most important thing to know about federal repayment plans is that there are a number of income-driven repayment plans.  What makes these plans special is the fact that borrowers are able to make payments based upon what they can afford rather than what they owe.  This key difference means that federal borrowers can avoid delinquency and default on their student loans, even if they lose their job.  The availability of income-driven repayment plans is an excellent consumer protection that is especially valuable for borrowers who fail to graduate school, struggle to find jobs in their field, or don’t earn enough money to pay off their debt.

[Further Reading: Strategy for Selecting the Best Federal Repayment Plan]

Private repayment plans are far more rigid and less forgiving of borrowers who find themselves struggling to meet their loan obligations.  Private repayment can begin as soon as the loan is issued or once the student finishes school.  Some lenders will make special accommodations for borrowers who cannot afford their payments, but these accommodations are normally on a case by case basis and far less flexible than the standard federal student loan options.

Student Loan Forgiveness

Perhaps the biggest perk with federal student loans is the availability of student loan forgiveness programs.  While student loan forgiveness on federal debt is still the exception rather than the rule, have this option helps borrowers avoid a situation where they have a mountain of student debt and no meaningful way of ever paying it back.

Two highlights of the federal student loan forgiveness options are the Public Service Loan Forgiveness program, which can lead to student loans being forgiven after 10 years of work in public service and the income-driven repayment plan forgiveness option, which can wipe away federal debt after 20 to 25 years.

Borrowers should expect and plan to pay off their debt in full, but by seeking out loans with forgiveness options, borrowers are protected should they end up in lower paying work or out of the workforce.

When it comes to private student loans, paths to student loan forgiveness are almost non-existent.

[Digging Deeper: 12 Methods of Student Loan Forgiveness]

Qualifying for Federal Loans and Private Loans

Getting federal student loans is fairly simple.  Borrowers must complete the FAFSA.  While there are some limited credit requirements to qualify for certain PLUS loans, gaining eligibility for these loans is far easier than for private loans.  Borrowers rich and poor alike will be able to get federal student loans.

Obtaining private student loans can be more difficult.  Borrowers fresh out of high school with a limited credit history and/or limited income will find qualifying for a private loan to be especially challenging.  For this reason, many private loan borrowers are required to find a cosigner for their loans.

Unfortunately, having a cosigner comes with additional challenges…

Private Student Loan Cosigner Issues

The most important thing that all borrowers and cosigners should understand is that the cosigner is legally responsible for paying off the student loan in full.

Even if the borrower promised the cosigner that they would make payments, if the cosigner is on the loan, the lender can require them to make payments if the cosigner misses payments.

Cosigners should also understand that the student loan will appear on their credit report.  This can potentially impact a cosigner’s credit score and debt-to-income ratio.

Cosigner issues can also have more than just financial consequences.  Ugly student loan situations can lead to serious disputes and hurt feelings between family members.

Lenders often advertise the existence of cosigner release programs, and while these options sound nice in theory, they are hard to obtain and offer the cosigner no protection should the borrower struggle to meet their obligations.

Federal and Private Loan Borrowing Limits

The big limit that applies to all forms of student aid is the Estimated Cost of Attendance (COA).  The COA is calculated each year by the school.

The total student loan borrowing plus any grants and scholarships cannot exceed the COA.  However, most students will find that the COA is a far higher number than what it actually costs to go to school.  Students who find that the COA is less than their actual expenses should view this issue as a major red flag and get into contact with their school’s financial aid office.

In addition to the cap on yearly student aid, federal student loans also have yearly limits.  These limits can be quite low for undergraduate students, but graduate students will usually find they are able to get ample amounts of federal student aid to pay for grad school.

The only other limit with private loans is imposed by lenders.  Based upon a borrower and cosigner’s credit score and debt-to-income ratio, a lender may cap the yearly and total borrowing that they are willing to issue.  These lending decisions are based upon the credit application rather than the actual cost of the school.

Federal Interest Rates vs. Private Loan Interest Rates

Federal interest rates are set by Congress and will vary depending upon the type of federal loan borrowed.  Generally speaking, federal student loan interest rates are good but not great.

Private student loan interest rates are set by lenders.  The borrower’s creditworthiness is a big factor in the interest rates that are offered.  Some private student loans have excellent interest rates that are better than the federal rates.  Other private loans have interest rates so high that they are closer to credit card interest rates.  Due to this wide range of possible interest rates, borrowers are advised to shop around with different lenders to find the best available interest rates.

Student Loan Fees

When selecting student loans, borrowers should pay special attention to the various fees that may be charged.

Prepayment penalties should always be avoided.  No borrower should accept loan terms that charge a fee for paying off the loan before it is due.

Loan origination fees are charged by the federal government.  This is a fee that is added to the balance of the loan from day one.  The origination fee should be accepted from the federal government, because it is the only way to get federal loans.  However, origination fees with private lenders should be avoided.  The majority of private lenders do not charge origination fees, so borrowers would be wise to steer clear of private lenders charging an origination fee.  Even if the fee charged by the private lender is relatively small, it can be the sign of a lender that is imposing terms that are not very friendly to consumers.  Smart borrowers should steer clear.

Bankruptcy

While there are differences in a student loan bankruptcy between federal loans and private loans, the thing all borrowers should understand before borrowing is that bankruptcy is nearly impossible on all forms of student debt.

The lack of a meaningful bankruptcy option raises the stakes on student loan borrowing.  Unlike credit card debt or mortgage debt, student loan debt can follow a borrower for life.

Because student loans lack this fairly standard consumer protection, it is critical that borrowers only borrow what is absolutely necessary and make certain they have a plan, and a backup plan, to pay back the debt in full.

The strict treatment of student debt in bankruptcy proceedings is yet another reason that borrowers should stick to federal student loans.  The repayment plan and forgiveness options protect people who might otherwise have no other option.

Other Student Loan Issues

Like bankruptcy, no college student expects to die at a young age or become disable.

Unfortunately, these tragic events happen.  As a result, it is important to select lenders who have favorable terms for borrowers who pass or become disabled before the loan is paid back.

Federal student loans have fairly strong forgiveness provisions for borrowers who die before the loan is paid off.  They also offer protections for borrowers who become permanently disabled.

On the private loan side, lenders can be far less accommodating.  Some lenders even have clauses in their contracts that require cosigners to immediately pay the loan off in full if the borrower dies.  Borrowers should avoid dealing with lenders who impose such terms.  Borrowers who are stuck with these terms on existing student loans should consider life insurance policies to protect the cosigners on the loans.

Why Choose A Private Loan Over a Federal Loan?

At this point it should hopefully be clear that federal student loans are a better option in most cases.

The exception would be for borrowers who have more financial assets and full confidence in their ability to repay.  These borrowers may seek out low interest private student loans in order to save money on the cost of borrowing.

These borrowers would giving up all of the federal student loan perks and protections solely for the slightly lower interest rates.

One example where this approach might make sense is for a borrower who only needs the student loan as a short-term loan.  Some federal student loans can come with origination fees and higher interest rates, so opting for a no-fee low interest private loan might make sense.

Ultimately, most borrowers will find that federal student loan interest rates are close to or better than the rates offered by private lenders.  The borrowers who find lower rates from private lenders should consider the extra cost of the federal loan to be an insurance policy.  Only if the insurance policy is way to expensive or completely unnecessary should a borrower consider private debt instead of student loans.

For most borrowers, federal student loans are the safe choice and the smart choice.