Published in: Student Loans | July 10, 2019

Here's Why Students Often Resort to Private Loans

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Federal loans are the most affordable. Why do so many students borrow privately?

Student loan application on deskImage source: Getty Images

With college costs going nowhere but up, many students need to borrow money to pay tuition bills. There are two choices for taking out student loans: federal and private. Federal loans are those made by the government -- specifically, the U.S. Department of Education. Private loans are made by banks, credit unions, and online lenders.

Federal student loans vs. private student loans

Both federal and private loans serve the same purpose: Allowing students to finance their education. The key difference is that federal loans offer more favorable terms for borrowers than private loans.

First, the interest rates of federal loans are regulated and capped so borrowers don’t spend excessively on interest. Private lenders can charge whatever interest they want. And whereas federal loans have fixed interest rates, private loan interest rates can vary and rise over time.

It’s also possible to get a federal loan without cosigner or credit check, so you don’t need to rely on anyone else to get money for college. Private loans are often credit-based, and if yours isn’t great, you’ll typically need a cosigner. This is often the case for high schoolers with no credit history.

Federal loans come with certain features designed to make the repayment process easier. For example, if you can’t keep up with your loan payments after graduation, you can get on an income-driven repayment plan, which recalculates your monthly loan payment as a reasonable percentage of your income. There’s also the option to defer your loan payments if you fall on tough financial times. Most private loans don’t offer the same protections. Some lenders will work with you if you reach out and ask for leeway.

Why students take private loans

If federal loans charge less interest than private ones and come with better terms, why do so many students borrow privately for college? Because federal loans come with a borrowing cap that limits the amount of money students can receive. Currently, that cap sits at $31,000 for undergraduate students who are also dependents (except for students whose parents are unable to get PLUS Loans). That $31,000 isn’t a yearly limit. It’s the total amount of federal loans you can take out for your undergraduate studies.

Meanwhile, the average cost of tuition at a public four-year, in-state college is $10,230 annually. Over four years, that's $40,920 -- more than the current federal loan limit. If you think that’s expensive, it’s only a fraction of the tuition cost at public out-of-state colleges and private universities. Students who attend pricier schools are even more likely to need private loans when their federal borrowing options run out.

Managing your private loans

There are a few ways to make taking private loans more manageable. First, aim to put extra money toward your loan’s principal to knock it out sooner. Doing so could save you loads of money on interest.

At the same time, pay attention to the interest rate on your loans. If it’s variable and keeps climbing, look into refinancing your student loans. Refinancing is a fancy way of saying “swap an existing loan for another.” Qualifying for a lower interest rate by refinancing will lower your monthly payments, too.

Finally, if you wind up struggling to keep up with your private student loan payments, reach out to your lender. As mentioned earlier, some will work with you if you’re having a hard time. They might allow you to defer payments temporarily or lower your interest rate.

It always pays to max out your federal borrowing options before resorting to private loans. But if you need to borrow privately, aim to find loans with the most favorable terms. Then be vigilant about paying them off as quickly as you can once you graduate.

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