How to Choose the Best Student Loans

What types of education loans are the best student loans?

Borrow federal first because federal student loans are less expensive, more available and have better repayment terms than private student loans. Federal student loans have low fixed interest rates that will not increase over the life of the loan, unlike variable interest rates which have nowhere to go but up. Perkins Loans and Direct Subsidized and Unsubsidized Loans do not depend on the borrower’s credit history and do not require cosigners. Federal student loans offer generous deferment and forbearance options, flexible repayment plans like extended repayment, graduated repayment, and income-based repayment, and a variety of loan forgiveness programs like public service loan forgiveness.

Private student loans should be considered only if federal education loans are insufficient or are no longer an option. For example, the student may have reached the loan limits or otherwise have lost eligibility for federal student loans (e.g., dropping below half-time enrollment or failing to maintain satisfactory academic progress). The student’s parents may be unwilling or unable to borrow from the Parent PLUS Loan program. Unlike federal student loans, private student loans may be available for previous school charges, for borrowers who are not seeking a degree or certificate (e.g., continuing education), for international students (usually with a creditworthy U.S. citizen or eligible non-citizen as cosigner), and for education costs incurred after graduation (e.g., bar study loans for law school graduates and residency and relocation loans for medical school graduates).

The Best Loan is the Lowest Cost Loan

For most borrowers, the best loan is the loan with the lowest cost. There are many factors that contribute to the cost of a loan, including interest rates, loan fees, subsidized interest, and loan forgiveness, discharge, and cancellation.

• The higher the interest rate, the higher the cost of the loan. A one percentage point increase in the interest rate on a fixed-interest loan typically increases the monthly payment by about 5% on a 10-year term, 9% on a 20-year term and 12% on a 30-year term. A loan with a variable interest rate might initially have a lower interest rate than a fixed-rate loan, but the interest rate may increase over the life of the loan. For example, a variable-rate loan may start with an interest rate that is competitive with the interest rate on PLUS Loans, maybe even a percentage point lower, but that interest rate might increase by a percentage point or two each year for several years, ultimately costing much more than the fixed-rate federal education loans. Given the current interest-rate environment, new variable-rate loans with a 10-year term may have an equivalent fixed rate that is about 3 or 4 percentage points higher than the loan’s initial interest rate.
• Loan fees are a form of up-front interest, and should be avoided by borrowers who expect to pay off their loans early, since the fees increase the cost of the loan. For example, a 6% loan with 4% fees may be the equivalent of a 7% loan with no fees if repaid over 10 years, but a 10% loan with no fees if repaid over just one year. A loan with a 4% fee is the equivalent of a no-fee loan with an interest rate that is about one percentage point higher on a 10-year term and about half a percentage point higher on a 20- or 30-year term.
• Subsidized interest is the equivalent of having a 0% interest rate during the in-school period and other periods of authorized deferment, because the federal government pays the interest on subsidized loans while the borrower is enrolled in school on at least a half-time basis.
• Loan forgiveness cancels all or part of the debt, directly reducing the cost of the loan.

Ranking the Best Loans

The best federal education loans are the Perkins Loan and the Direct Subsidized Loan. These loans provide subsidized interest, low interest rates, and low fees. Next are Direct Unsubsidized Loans, followed by the PLUS Loan. Private student loans have interest rates that depend on the borrower’s credit scores and debt-service-to-income ratios, as do home equity loans and other non-education loans. Most private student loans require a creditworthy cosigner. Credit cards often have some of the highest interest rates and require monthly payments that start off higher and gradually get smaller, because the monthly payment is usually based on a fixed percentage of the outstanding loan balance, instead of the level, graduated, or income-based repayment plans available for student loans.

Federal and private student loans do not require the borrower to pledge a home or other asset as collateral. If the borrower defaults on a home equity loan, he or she can lose the home. If the borrower defaults on a student loan, the lender cannot repossess the student’s education.

This chart compares some of the major features of federal and private student loans.

After cost, secondary factors that can help distinguish loan programs include who is responsible for repaying the debt (e.g., the student or the parent/cosigner), flexible repayment and deferment options, and the quality of lender customer service.