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Choosing between Federal and Private Student Loans

Sep 04, 2019

Wouldn’t it be great to have enough money — whether scholarships, grants, income or savings — to cover all the costs? Unfortunately, with sky-rocketing college costs, this is not the reality for most families. The gap filler for most is a loan. This then begs the question of which loan is best for you.

For students, the choice is pretty simple: the Federal Direct Student Loan program offers the lowest interest rates and most flexible repayment terms for students. Current students will pay a fixed rate of interest of 4.53% over the life of the loan, and an origination fee of approximately 1.06%. The standard repayment term is 10 years. When it’s time to start repaying the loans, students may pick from a number of flexible repayment plans, some based on the student’s income.

Direct student loans are easy to get – as long as the student follows the government’s process.  All students, no matter their family’s income qualifies for a Direct Student Loan. Students from low-income families may be eligible for Subsidized Direct Loans with the benefit of having the government pay interest on the loan while the student is in school. Two catches: (1) to get Direct Loan, students MUST file the FAFSA form, which is available October 1 for the next academic year. No FAFSA – no loan or any other federal student aid. (2) The federal government caps the amount a student may borrow based on their year of study. First-year students may borrow up to $5,500; 2nd years, $6,500; 3rd and 4th-year students may borrow up to $7,500/year.

Federal loans are often packaged as financial aid, but it’s important to remember that they are not free and will need to be repaid with interest.  

If a student does not file a FAFSA or needs to borrow more than the federal government’s cap, they will have to borrow from a private lender such as a credit union. Few undergraduates meet private lender credit tests but still may be eligible for a loan using a cosigner — often a parent or guardian willing to pay the loan if the student cannot.

In effect, the cosigner lends their good credit rating to the student, so they can obtain the loan. Many private lenders permit the cosigner to be dropped from the loan using a feature known as the cosigner release. Cosigners may be released after a certain number of on-time payments are made, and the student contacts the loan servicer to obtain the release. 

Parents who want to borrow to help their children pay the college bill also may choose between a federal loan, the Plus loan, and private lenders. The federal government’s Plus Loan Program permits parents to borrow up to the full amount of their unmet need with a minimal credit test of “no adverse credit.” The current interest rate is 7.08%, with an origination fee of approximately 4.24%. The parent is the sole borrower and does not have the option to transfer the loan to the student in the future.

Private credit student loans are offered to parents using credit criteria that may be very similar to that used to decision loans to students. The interest rate is based on the parent’s credit profile with stronger credit ratings being offered lower interest rates. Frequently, lenders do not charge parents a fee to originate the loan.

Generally, parents with very good to excellent credit histories will be offered loans without fees and interest rates lower than the federal PLUS program. These parents trade-off more flexible repayment terms offered by the federal government for a potentially lower interest rate and no fees.

No matter who is borrowing, parent or student, and which program is accessed, federal or private, borrowing as little as possible is key. Equally important is ensuring that the required loan payment will be manageable BEFORE signing on the dotted line.