7 Key Things You Should Know About How Private Student Loans Work

 February 26, 2021
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7 Key Things You Should Know About How Private Student Loans Work
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Before borrowing a private student loan for college, it’s important to understand how private student loans work. While these loans provide funding for school, they have some key differences from their federal student loan counterparts.

For one, you might need a cosigner to qualify for a private student loan. And for another, your private student loan won’t be eligible for federal repayment plans, protections or forgiveness programs.

If you’re looking into how to apply for private student loans, we’ve compiled a few important facts to help you decide if private college loans are right for you.

How do private student loans work? 7 key facts

Both parents and students can apply for private student loans. Here are seven key things you need to know before applying.

1. Private student loans provide extra funding after maxing out federal loans
2. Private loans for students are harder to qualify for than federal ones
3. Interest rates and loan terms vary among private student loans
4. Private student loans offer less flexibility in repayment plans
5. Private college loans typically don’t qualify for loan forgiveness
6. There arefewer options for financial hardship with private loans
7. Private college loans are difficult to discharge in bankruptcy

1. Private student loans provide extra funding for college after maxing out federal loans

Federal student loans, including subsidized direct loans and unsubsidized direct loans, should be your first choice for college funding. They tend to come with low interest rates and flexible repayment terms. Plus, you don’t need to meet credit requirements to borrow most federal student loans.

So before applying for any private loans, complete your Free Application for Federal Student Aid (FAFSA) — this guide to filling out your FAFSA can help — and make sure to exhaust federal direct loan options first.

However, there is a maximum limit to federal student loans. You might hit your borrowing limit and still need funding for school. In this case, it could make sense to consider private loans.

Note that private lenders typically let you borrow up to the cost of attendance of your school, minus any other financial aid (e.g., federal student loans or grants) that you’ve already received.

2. Private loans for students are harder to qualify for than federal student loans

Almost anyone can qualify for federal student loans, as long as you meet basic eligibility criteria, such as being accepted to an approved program and not being in default on student loans.

Private student loans, however, require you to qualify based on your credit score. Private lenders also look at your debt-to-income ratio, which is the number of monthly debt payments compared with your monthly gross income. If you don’t have enough income, private lenders will not approve a loan.

Since many students don’t have much or any income, and because they often lack a credit history, lenders might require students to have a cosigner to qualify for private student loans. Even if you can qualify on your own, adding a cosigner to your application could potentially help you get a better interest rate.

3. Interest rates and loan terms vary among private student loan lenders

When you apply for federal student loans, the interest rate is determined based on loan type. This chart shows current interest rates for federal loans, as of Feb. 3, 2021.

Loan Type Borrower Type School Year 2020-21
Direct subsidized Undergraduate 2.75%
Direct unsubsidized Undergraduate 2.75%
Direct unsubsidized Graduate/Professional 4.3%
Direct grad PLUS Graduate/Professional 5.3%
Direct parent PLUS Parent 5.3%

When you apply for private student loans, there is no standard interest rate. Instead, different private student loan lenders set their rates. The rates individual applicants receive vary depending upon their credit scores, incomes and credit history.

On the plus side for private loans, they don’t always include an origination fee the way federal loans do. Be sure to consider at those fees, charged when the loan is taken out, when you’re comparing the cost of the loans.

Private student loans may also have variable interest rates, rather than fixed rates. With a variable rate loan, the interest rate is usually influenced by LIBOR or Fed interest rates.

While variable rates typically start lower than fixed ones, they could rise over time. If your interest rate increases, your monthly payments and interest costs could go up, making your overall loan costs higher.

4. Private student loans offer less flexibility in repayment plans

When you obtain college loans from the federal government, you have many different repayment options, including income-driven repayment arrangements and a standard or graduated repayment schedule. Because you have various options, you can choose the repayment plan that works for you.

Private student loans typically have fewer choices for repayment and do not offer repayment plans based on income. If you can’t find a job after graduation or if your income is low, you’ll still be expected to repay the private loan based on the payment amount agreed to when you borrowed.

5. Private college loans typically don’t qualify for loan forgiveness

Students with federal loans can be eligible for Public Service Loan Forgiveness and other federal forgiveness programs if they fulfill specific requirements related to work and payment history. Students on income-driven plans can also have remaining balances on their debt forgiven after 20 to 25 years, depending upon the program — although forgiven debt is taxable as income.

Private loans for students do not qualify for federal loan forgiveness options. Even if you work your whole career in public service and have your federal loans discharged, you will still likely be expected to repay your private loans in full.

That said, there are a few private and state-run loan repayment assistance programs that will help you pay off private student loans. It’s worth checking out what your state offers to see if you could qualify.

6. There are fewer options for financial hardship with private student loans

If you find yourself struggling with payments on your private student loans, you have more limited options than with federal student loans.

With federal student loans, you can adjust payments via an income-driven repayment plan or pause them completely through deferment or forbearance.

Private student loans don’t qualify for these federal programs, though some private lenders will let you skip a payment or pause payments in the event of financial hardship.

These benefits vary by lender, so make sure to look for these protections before choosing a loan.

7. Private college loans are difficult to discharge in bankruptcy

Although private student loans are not offered or guaranteed by the federal government, they are still treated differently than many other kinds of consumer debt. Like with federal loans, it is very difficult to discharge private student loans in bankruptcy.

Private college loan cosigners could still be held responsible for repayment even if the student suffered extreme hardship that justified discharge in bankruptcy.

That said, private lenders don’t have as many avenues to collect on a defaulted loan as the federal government does. While they can bring you to court over a loan in collections, they can’t offset your tax refund or Social Security benefits. What’s more, private student loans come with a statute of limitations, which varies by state, whereas federal student loans do not.

How to apply for private student loans

Although private student loans can come with serious drawbacks compared with federal student loans, they can be useful if you need additional funding for undergraduate or graduate school. Just make sure not to borrow more than you can afford to pay back.

Now that you know how private student loans work, let’s go over how to apply for private student loans. When applying, make sure to shop around for different private student loan lenders and compare:

  • Eligibility requirements
  • Application fees and origination fees
  • Interest rates and available interest rate deductions or discounts, such as a reduced rate for automated payments
  • Loan terms, including repayment term and prepayment penalties
  • Reviews of the loan servicer

You’ll also need to gather information including details about your income, your tax returns and information about your financial assets. With this information in hand, you can apply for loans with different banks, credit unions and other financial institutions.

You can start by looking at our private student loan marketplace to see what types of loans lenders are offering. If you think you’ve found the right loan for you, apply for the money necessary to cover the costs of your schooling, but avoid taking on too much debt.

Rebecca Safier contributed to this report.

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