College is an exciting prospect. A time for spreading wings and setting out on one’s own. Paying for it isn’t as fun. Many students turn to loans, and quickly discover there are two major types: federal and private. But how do they work, what are the differences and why do students pursue one or the other?
Federal student loans are almost always a better deal than private loans. Federal loans have much better interest rates and repayment options and are easier to get. Students should make use of private loans only when they can’t avoid it. We explain below.
Federal student loans or private? The Federal student aid website offers information on federal student loans.
Federal loans come mostly from the U.S. government. There are two kinds: “Direct,” where the money is loaned directly to the student, and “PLUS,” where the parent is usually the primary borrower. They generally have lower rates and better repayment options than private loans. They come as both subsidized and unsubsidized loans.
Private loans come from banks and other financial institutions. They tend to have comparatively high rates and less attractive repayment options than federal loans. The differences break down as follows:
Interest Rates
Federal loans have low fixed interest rates. See the table of federal student loan rates below.
Image source: studentaid.ed.gov
Private student loans, by contrast, can carry interest rates in excess of 18%. Worse, the rates can be variable, which means they’ll most likely increase throughout the life of the loan.
Interest on some federal student loans like, subsidized loans, doesn’t start to add up until graduation. This grace period can give students a welcome break. Private loan interest almost always starts accruing right away.
Repayment Options
Handy graphic from StudentAid.ed.gov about federal student loan repayment options. Click to expand.
Federal student loans don’t require repayment until after graduation, or if a student leaves school or changes their enrollment to less than half-time status. Private student loans, by contrast, often require students to start paying back the money while they’re still in school.
Federal loans come with helpful repayment options. One federal loan repayment option ties the graduate’s monthly payment to their income level. Another forgives the loan debt in part or entirely in exchange for participation in certain public service programs. For example, a stint in the Peace Corps can wipe out a student’s federal loan debt. Private loans seldom come with any such options.
Ease of Acquiring Student Loans
Federal student loans don’t require credit checks in most cases. They also don’t require cosigners. Private loans usually require credit checks. In the event a cosigner is needed, the consequences of default on a private loan can be stout. According to ABC News, when Freddy Reynoso died in a car accident, his father Francisco, a self-employed gardener from Palmdale, California, was stuck with $200,000 in college debt. While Freddy’s federal loans were forgiven instantly, debt collectors hounded his father incessantly for the private portion of his debt, eventually driving him to bankruptcy.
A Caveat to Federal Student Loans
Defaulting on federal student loan payments gives the government the right to attach your wages. Here’s a sample wage garnishment letter from the IRS.
Federal student loans do have drawbacks. One is that if the borrower defaults on the payments, the U.S. government can garnish wages without a court order. They can also confiscate tax refunds and/or social security checks until the loan is repaid. Unlike other loans, Federal loans can never be discharged through bankruptcy: they stay with you forever.
Why Get a Private Loan?
If private loans have most of the downsides, and federal student loans win in so many categories, why get a private student loan? In a word: limits. A student may run out of federal loan money before their tuition is completely paid for. They may therefore have no choice but to supplement their college finances with private loans. Limits on federal loans can change over time, and are visible by clicking here.
Federal Student Loan Limits:
Even if federal loans don’t fully cover a student’s tuition, it’s a good idea to exercise caution before seeking private loans. Students who want to avoid the high interest and meager repayment options of private loans can apply to a slightly less expensive college. Though not the most attractive choice, when weighed against the potential pitfalls of private loans, it’s worth considering.
In a Nutshell
The handy chart below outlines all the various types of student loans and aid. Click to expand.
Sources
- Graduates, Parents Riddled With Student Debt Turn to Bankruptcy – ABC News
- ABC News article on father and son tragedy:
- What are the main differences between federal student loans and private student loans? – Consumer Protection Finance Bureau
For more information on federal student loans, visit the federal student aid website at https://studentaid.ed.gov/types/loans.