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There are two main types of student loans: federal and private. If federal student loans don’t cover the anticipated gap between what your family can contribute and the cost of attendance, your school might suggest you take out private loans, too.
But private loans don’t offer the same protections, repayment options or low interest rates that federal loans do. That’s why it’s best to exhaust your federal loan options before turning to private loans. Nearly half of private student loan borrowers in 2011-12 didn’t take out federal loans when they could have, according to the Institute for College Access and Success — meaning they accepted less favorable loan terms than they were eligible for.
Understanding the differences between the types of loans will better prepare you to pick the right ones early on, manage them while you’re in school and repay them effectively when you graduate.
What are the main differences between federal and private loans?
1. Private loan interest rates are credit-based
Federal student loans are available to all borrowers regardless of credit history. You won’t need to pass a credit check or get a cosigner, which is a parent or other trusted adult who agrees to be responsible for repaying the loan if you can’t. Federal student loan interest rates are set by Congress each year, and while different federal loan programs have different interest rates, all borrowers eligible for a particular type of loan get the same rate.
Direct Unsubsidized Loans taken out after July 1, 2015, for instance, have an annual interest rate of 4.29% for undergraduates and 5.84% for graduate and professional students. So all undergrads with such loans will pay 4.29% on them and all grad students will pay 5.84%.
That’s not the case with private loans. They’re based on you or your cosigner’s credit history, meaning the higher your credit score. the lower the interest rate you’ll qualify for. If, like most undergrads, you haven’t build up sufficient credit to qualify for a loan on your own — meaning you don’t have your own credit card, car loan or utility bills that contribute to your credit history — you’ll need a cosigner to qualify.
2. Federal loans have lower interest rates
Federal loans have historically had lower interest rates than private loans. Interest rates on federal loans are also fixed, so they won’t change while you’re in repayment. For loans taken
out after July 1, 2015, federal rates range from 4.29% to 6.84%.
Most private loans, on the other hand, come with variable rates, which can go up or down over time based on the economic index they’re tied to. In August 2015, for example, private loan interest rates ranged from 2.75% to 13.25%, depending on the borrower’s or cosigner’s credit history, according to the New York State Higher Education Services Corporation .
While the lowest available variable rate might be lower than federal interest rates at a certain point, keep in mind that variable rates can increase. In 2011, for example, they climbed to as high as 19% for some borrowers, according to the Consumer Financial Protection Bureau. Check your private loan agreement to see how often variable rates are adjusted; it could be monthly, quarterly or yearly. Less-frequent adjustments mean fewer opportunities for rate increases.
3. Private loans have fewer borrower protections
Federal student loans come with several benefits that private loans don’t:
- Federal loans offer all borrowers deferment and forbearance. which are opportunities to stop making payments for a specified period of time if you’re unemployed or experience another financial hardship. Private lenders aren’t required to provide deferment or forbearance, though many have similar, somewhat less generous programs. That means you won’t have the same level of flexibility if you having trouble paying off private loans.
- If you have financial need and received subsidized federal loans, the government will pay the interest on your loans while you’re in school or if you defer them when you’re unemployed. Private lenders don’t offer subsidized loans.
- You’ll be eligible for Public Service Loan Forgiveness if you work in public service and make 120 on-time monthly payments on your federal loans. You also have multiple repayment options, some of which tie your payments to your income and will forgive your loans after 20 or 25 years. Private loans don’t offer such income-driven plans, though some offer graduated or interest-only repayment periods.
- If you miss a payment on your private loans, you’ll most likely immediately go into default. instead of receiving the nine-month pre-default delinquency period that federal loans offer. You could be sued by the debt collector and a see your credit score take a hit. But unlike the federal government, private lenders don’t have the power to garnish your wages or automatically apply your tax refund to your outstanding debt.
- It’s difficult to get a cosigner removed from a private loan, which can be a major problem if a cosigner declares bankruptcy or dies. A full 90% of borrowers who applied to have their cosigner removed from their loans were rejected by private lenders, according to a June 2015 report by the Consumer Financial Protection Bureau .
The bottom line
Your best bet is to take out exclusively federal loans so you’re able to take advantage of their fixed interest rates, multiple repayment options and forgiveness benefits. If taking out a private loan is the only way for you to afford your college of choice, read your loan agreement carefully. Make sure you fully understand the potential risks of taking on a cosigner, choosing a variable interest rate or missing future payments. You’ll feel more empowered to pay off your loans, whether they’re federal or private, when you understand exactly what you’ve signed up for.