While an overwhelmingly large number of student loans are of the federal variety, many students also need to borrow from private lenders to fill the cost gap to pay for college. As the average 2016 college graduate walked away with $37,000 in student loans and the maximum unsubsidized federal lending amount is $12,500 annually, students attending more expensive colleges will most likely need private assistance. Another reason to consider private loans is that their interest rates might be lower than federal loan interest rates in certain instances. Private student loans are a realistic option to finance college and it is important to learn the basics about private student loans and how they can benefit you.
When comparing federal and private student loans, the most important number to look at is the interest rate. All federal student loans come with a fixed interest rate that will remain the same amount for the life of the loan. Fixed interest rates are the most popular option for private student loans as well. This is because nobody can predict if interest rates will be the lower, the same, or higher than the current interest rate when the student loans are disbursed. As student loans are currently near historic lows and many financial experts are predicting key interest rates are going to be increasing in the foreseeable future, fixed rates are a better option if you will need most (or all) of the 10-year repayment period to repay the student loan payments.
If you are a college senior or fairly certain you will have a high starting salary for your first job and will be able to pay your student loans early, a variable rate is an excellent option to consider because of smaller interest payments. Variable rates are often lower than fixed interest rates, but, if interest rates rise sharply, the variable student loan interest rate will increase proportionally and end up costing you more in interest charges than a fixed interest rate.
Unlike federal loans, private lenders offer different interest rates based on several factors. The most common factor is an applicant’s creditworthiness that includes their credit score and payment history. Lower interest rates will be awarded to applicants and co-signors with excellent credit scores and no recent missed payments. Private lenders also differ in how they determine their interest rates as some lenders use the London Interbank Offered Rate (LIBOR) or Prime Lending Rate) and add a small marginal interest rate as well.
In addition to applying for a fixed or variable interest rate loan, another way to control the total loan cost is by determining how much you can afford each month while in-school and after the loan enters repayment status. A college senior will probably have more financial flexibility than their freshman counterparts because they will be entering the workforce soon to begin replenishing their savings. Private and federal student loans allow you to make payments while still enrolled in school. As all student loans begin accruing interest the day of origination, making any payments as soon as possible will save you money in the long-run. Regardless of which repayment option you choose below, signing up for automatic payments will reduce the interest rate 0.25% with most lenders, and, they will not penalize you if you repay the entire balance ahead of schedule.
Full In-School Payments
The least common payment method, but most cost-effective, is to make full payments as soon as the loan is issued. This repayment method is comparable to an auto loan or home mortgage where the money goes directly to the seller and the buyer begins repaying the lender immediately. As colleges require all tuition and fees to be paid at the start of each semester, many families need to borrow the lump sum and repay the balance each month from their regular paychecks.
A more popular option is making interest-only payments while you are still a college student. As many college students can only work part-time and still have time to study and attend class, interest-only payments are achievable with most college budgets. These small monthly payments help prevent new college graduates from getting a surprise bill for several thousand dollars of deferred interest that is rolled into the borrowed principal when the student loans enter repayment status. If they do not have the money to payoff the accrued interest at this point, it will begin earning interest on interest.
This might be the most popular option for many college students and families when it comes to repayment, but, it can also be the most expensive student loan option. Most lenders will allow student borrowers to defer all principal and interest payments until the loans enter repayment status 6 months after graduation. While no payments of any kind are required during college, interest accrues each day. Four years of fully deferred loans will have a large amount of accrued interest that will need to be paid during the grace period before it becomes part of the borrowed principal that can increase your loan balance by several thousand dollars. If this happens, you will also be paying “interest on interest.” To avoid additional interest charges, it might be a good idea to consider making interest-only payments while still in school whenever it is financially possible.
Benefits of Private Student Loans
While federal student loans are the most common financial tool, private loans have multiple benefits as well. Here are some reasons that private student loans can be a better option for you.
- Variable interest rates are lower than fixed federal or private loan interest rates
- Bridge the “financial gap” for more expensive colleges that cost more than the annual $12,500 federal borrowing limit
- Most private lenders allow repayment terms up to 15 years
- Over 1 million student borrow from private lenders each year
Downsides of Private Student Loans
Private student loans are a popular option for many families but they might not always be the best option. Here’s why:
- Fixed interest rates tend to be higher than federal loans
- No subsidized interest rates offered
- Fewer loan forgiveness and deferment options than federal loans
- Co-signors are more likely to be required
- Applicants with less-than-perfect creditworthiness might not qualify for the lowest advertised interest rates