When it comes to student loans, there are two basic options: federal student loans, which are the most common choice, and private student loans from a lender such as a bank.
Federal loans have some excellent benefits and tend to be the easiest to get and the most flexible of the two options, so why would a borrower consider private loans? Here is a primer on some of the differences between federal and private student loans, as well as some of the benefits of each type.
Federal loans have some clear advantages ...
When you hear about Americans' $1.2 trillion in student loan debt, the vast majority of that amount (about $1 trillion) is in the form of federal student loans, and for good reason. There are many distinct advantages of federal loans that appeal to borrowers.
Some of the benefits of federal student loans include:
- You don't have to start repaying federal loans until you've been out of school for six months. Private loans may require repayment while you're in school.
- Fixed interest rates -- many private loans have variable rates
- Students with financial need may qualify for subsidized loans, meaning the government pays the interest while you're in school
- No credit check -- Federal student loan eligibility isn't dependent on having a good credit score, but private loan approval is
- Interest may be tax-deductible
- If you have trouble repaying, you might be able to lower or postpone your payments (forbearance or deferment)
- Several repayment plans to choose from, including some that adjust your payments according to your income
- Opportunity for loan forgiveness (teachers, public service employees, and anyone on an income-dependent repayment plan)
- No prepayment penalty or fee
Some of these features may be available with private student loans (such as being able to defer payments while in school), but no private student loan will have all of the perks mentioned, especially the flexibility in repayment options and the opportunity for loan forgiveness.
... but private loans can be the best choice for some borrowers
Despite all of the perks of federal student loans, there are several situations where private student loans may be the best option.
For many borrowers, for instance, the maximum amount you can borrow through federal student loans might not be enough. A first-year undergraduate student can only borrow up to $5,500 for the entire year if they are considered to be a dependent, and up to $9,500 if they're independent. With the cost of attendance at many schools far exceeding this amount, federal loans by themselves may not be enough.
Private loans can be a good option for parents or other relatives to borrow money for a student's educational expenses. Parents are eligible for Federal PLUS loans, but there are drawbacks to this type of loan, including a rather high loan fee of about 4.3% in addition to the interest charged.
Speaking of interest, with bank interest rates near record lows, it may be possible to obtain a private student loan at a lower interest rate than a federal loan. This especially applies to graduate students and parents. While the current federal undergraduate interest rate of 4.66% is very competitive with the private market, the current interest rate for graduate direct loans is 6.21%, and for PLUS loans the rate is 7.21%.
If you have good credit, it may be possible to obtain a lower interest rate from the private lending market, especially if you plan on paying off your loan in a relatively short period of time (say, 10 years). A quick search shows companies offering private loans with fixed interest rates of 5.74% and variable rates as low as 2.25%.
It depends on your unique situation
For the most part, federal student loans are the better option, if they meet your needs. However, if you need to borrow more than federal loans will allow, you're a graduate student, or you want to borrow for a child, grandchild, or other relative, the private student loan market may be a good option to consider.