Introduction to Private Student Loans

Private student loans, also known as alternative student loans, are non-federal education loans. The interest rates, fees and other terms of private student loans are set by the lender, not the federal government. Private student loans are not guaranteed or subsidized by the federal government. Private student loans are made by banks, credit unions and other non-bank financial institutions. They are also made by state agencies (state private student loans), as well as colleges and universities (institutional private student loans).

Private student loans represent about 8 percent of annual new student loan dollar volume, after peaking at about a quarter of annual volume in 2006-2007 and 2007-2008. Private student loans also represent about 14 percent of student loans outstanding.

Eligibility for Private Student Loans

Most private student loan programs base eligibility on the borrower’s credit scores, income and debt-to-income ratios.

Private student loans, unlike federal student loans, are subject to the defense of infancy. Accordingly, students who have not yet reached the age of majority for the student’s state of legal residence may not be able to qualify for a private student loan without a cosigner.

Most new private student loans are school certified. The lender will confirm with the college or university financial aid office that the student is enrolled and eligible to receive a private student loan. In addition, the financial aid administrator will tell the lender the maximum amount the student may borrow after subtracting all other aid from the college’s annual cost of attendance. The lender may further reduce the amount the student may borrow.

Private student loan borrowers are not required to file the Free Application for Federal Student Aid (FAFSA). However, filing a FAFSA is recommended, to ensure that the student receives all of the federal financial aid funding for which he or she is eligible, including grants and other gift aid.

A Cosigner may be Required

More than 90 percent of new private student loans require a creditworthy cosigner, such as a parent or other relative. Even if a borrower can qualify for a private student loan on his or her own, the borrower may wish to get a cosigner. Lenders not only base eligibility for private student loans on the higher of the borrower’s and cosigner’s credit scores, but also the loan’s interest rates and fees. Higher credit scores lead to a lower-cost loan.

Note, however, that a cosigner is a co-borrower, equally obligated to repay the debt. A cosigner is not merely enabling the borrower to obtain a loan, but is also accepting equal responsibility for repaying the debt. A cosigned loan will show up on the cosigner's credit reports and will be treated as though it were the cosigner’s own loan. This can affect the cosigner’s ability to obtain and refinance other debt, such as mortgages and other consumer credit. Late payments on a cosigned loan will damage the credit of both the borrower and cosigner. Many lenders will start seeking repayment from the cosigner after the first late payment.

Some lenders offer cosigner release options, where a cosigner may be removed from his or her obligation to repay the debt after the borrower makes the first 12, 24, 36 or 48 consecutive, on-time payments. However, the borrower must also satisfy credit criteria, such as having a high credit score and having a stable job with enough income to have been making the monthly loan payments. Depending on the lender, borrowers and cosigners may have difficulty qualifying for cosigner release.

Differences between Federal and Private Student Loans

There are many differences between federal and private student loans. Some of the more noteworthy differences include differences in interest rates, credit underwriting and cosigner requirements, loan limits, eligible uses, and options to suspend or reduce loan payments.

Most private student loans offer variable interest rates, which may increase over the life of the loan. Federal student loans offer fixed rates, which yield more predictable loan payments. However, more than half of private student loan programs offer fixed interest rate options.

Since the interest rates on most private student loans are based on the credit scores of the borrower and cosigner, if any, the advantage of a federal student loan as compared with a private student loan may depend on the individual borrower. For example, interest rates for borrowers with excellent credit may be competitive with the interest rates on some federal student loans, such as the Parent PLUS Loan and Grad PLUS Loan.

Some private student loans offer borrowers a lower interest rate if they agree to make interest-only payments during the in-school and grace periods. This not only yields a lower-cost loan, but avoids interest capitalization, which can cause the loan balance to increase. However, not all borrowers can afford to make loan payments during the in-school and grace periods.

Like federal student loans, most private student loans offer an interest-rate reduction to borrowers who repay their loans using an automatic monthly transfer from a bank account. Federal student loans offer a 0.25% interest-rate reduction for automatic- debit (auto-debit) programs. The interest-rate reduction for private student loan programs varies by lender, but is typically either 0.25% or 0.50% for the programs that offer it.

Both federal and private student loans are eligible for the student loan interest deduction.

Private student loans generally offer higher annual and cumulative loan limits than federal student loans.

Unlike federal student loans, private student loans may be available for previous unpaid school charges, for students who are enrolled less than half-time, for (legal) bar study course , for residency and relocation expenses, for continuing education and for international students (with a creditworthy U.S. citizen or permanent resident as a cosigner).

Some private student loan programs offer death and disability discharges similar to the ones available for federal education loans. Private student loans are not eligible for public service loan forgiveness and other federal loan cancellation options. Forbearances on private student loans are generally limited to 12 months, unlike the 3-year limit on federal education loans.

A private student loan consolidation is like a traditional refinance, where a new loan pays off the balances on the previous loans. The new loan has a new interest rate based on the borrower’s current credit profile. In contrast, a federal consolidation loan has an interest rate that is based on the current interest rates of the previous loans.

Choosing a Private Student Loan

For most families, choosing the best student loan should focus on the cost of the loan. But few private student loan programs provide up-front pricing before the student applies for the loan, since the interest rates and fees are based on the credit scores of the borrower and cosigner, if any. Most students do not get the lowest advertised interest rate on a private student loan, since few students have 800+ credit scores. Instead, the student should apply to several private student loans to get personalized pricing.

Students and parents have a tendency to choose well-known lenders over less well-known lenders, even though regional and specialty lenders may offer lower interest rates.

So, families should shop around, trying to find the lowest-cost loans available to them. Generally, applying to several private student loans will not affect the credit scores of the borrower and cosigner by much. The credit reporting agencies now recognize when a prospective borrower is shopping around, not trying to get multiple loans.

Students and parents can search for private student loan programs on PrivateStudentLoans.com.

Borrow Smart

Before borrowing from either federal or private student loans, students should focus on the free money, such as scholarships and grants, as well as savings and family resources. Students should file the FAFSA (Free Application for Federal Student Aid) to qualify for need-based grants and student employment. They should also search for scholarships using free scholarship matching services.

After students have exhausted eligibility for gift aid (i.e., scholarships and grants), the money that does not need to be repaid, they can consider using federal and private student loans to finance the remaining college costs. But borrow smart, limiting total student loan debt to affordable levels. Total student loan debt at graduation should be less than the student’s expected annual starting salary, and ideally, a lot less. If total student loan debt at graduation is less than the annual income, the borrower will be able to repay his or her loans in ten years or less.

Prospective borrowers should also borrow federal first, because federal student loans are less expensive, easier to get and have more flexible deferment and repayment terms. Private student loans should be used mainly when the student has exhausted his or her eligibility for federal student loans. Private student loans should supplement, not supplant, federal student loans, and should be used in moderation.

In 2011-2012, about a quarter of undergraduate private student loan borrowers did not borrow from the Direct Subsidized and Unsubsidized Loan Programs, and more than a quarter borrowed less than the maximum Direct Subsidized and Unsubsidized Loan limits for which they were eligible. Only about 15 percent of dependent students who borrowed from private student loan programs also had parents borrowing from the Parent PLUS Loan program.

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