Picking a student loan that meets your needs requires an understanding of some basic concepts. This article explains the difference between undergraduate federal and private loans.
What’s the difference between federal vs private loans?
The fundamental difference is the lender.
- The federal government, specifically, the U.S. Department of Education, is the lender for all federal student loans.
- Private loans are made by others: banks, credit unions, credit card companies, colleges and universities, agencies created by states, specialty finance companies, etc.
In 1965, Congress passed the Higher Education Act to set up a way for students to borrow money for college. The goal was to provide access to higher education to any student who wanted to go to college – regardless of income or assets. Over time, a separate program was established for parents to help their children.
Private loan programs issue loans to students who need more money than the government would lend them, while other students might skip the federal loan program entirely and take private loans to avoid filing the paperwork necessary to get a federal loan.
The Federal Student Loan Programs
The U.S. Department of Education (DoE) loans money to families under the William D. Ford Federal Direct Loan Program (a.k.a. Direct Loans). There are four Direct Loan types:
- Direct Subsidized: for students
- Direct Unsubsidized: for students
- Direct PLUS: for parents
- Direct Consolidation: for students or parents
To be eligible for a Direct Loan, borrowers must file a FAFSA form (“Free Application for Federal Student Aid”) after October 1st for the academic year that begins the following year. Students seeking a federal loan for the academic year 2022-23, which begins in the summer of 2022, need to file the FAFSA form after October 1, 2022.
Subsidized vs. Unsubsidized Direct Loans
The DoE uses the FAFSA form to capture information about the family and the student to determine a student’s eligibility for a Direct Subsidized Loan. Subsidized loans are need-based and relieve students from the responsibility for interest that accumulates during the in-school, grace, and deferment periods.
Unsubsidized loans require students to either pay the interest during those periods or to capitalize the interest. Students who capitalize interest choose not to pay the interest due on the loan. Instead, they elect to add that amount of unpaid interest to the principal amount of the original loan.
The federal government caps the amount of Subsidized and Unsubsidized Direct Loans that a student may borrow based on their year of study.
- 1st Year students: $5,500 maximum borrowing
- 2nd Year students: $6,500
- 3rd and 4th year students: $7,500/year
Loan Terms and Conditions
The process for applying for a Direct Loan starts with filing the FAFSA. The DoE then provides information to the student’s college, which offers student aid, including Direct Loans, via a Financial Aid Award Letter. The Financial Aid Award letter will detail a student’s eligibility for Direct Subsidized and Direct Unsubsidized loans.
- Are made at a fixed rate of interest. The rate for loans for undergraduate borrowers made on or After July 1, 2022 will be 4.99% for Federal Direct Loans
- Charge an Origination Fee
- Offer many flexible repayment plans
- Require borrowers to go through Entrance and Exit Counseling
- Do not require students to undergo a credit check before getting a loan
Student loans, like other financial instruments, require borrowers to enter into a binding contract that discloses the requirements of the loan and outlines the borrower’s responsibility for repaying the loan. The DoE uses a Master Promissory Note (MPN) to obligate the borrower to repay the loan. Many colleges permit students to use one MPN for all four years of college.
Direct PLUS loans
Direct Plus Loans are issued to parents of dependent undergraduate students (a.k.a. Parent Plus Loans) and to graduate and professional students (a.k.a. Grad PLUS Loans).
Unlike other Direct Loans, Parent Plus and Grad Plus Loans are credit tested. Borrowers cannot have an Adverse Credit History as defined by the DoE. Borrowers can be denied a Plus Loan for several reasons including a prior student loan default or having balances greater than $2,085 that are at least 90 days past due, among other knock-out criteria.
Direct Plus Loans:
- Offer a fixed interest rate: 7.54% for Plus loans made on or after July 1, 2022.
- Charge an Origination Fee
- Have a cap on the amount that may be borrowed. The Parent Plus Loan cap amount is the college’s cost of attendance (minus other financial aid).
Under the Parent Plus program, the parent is the sole borrower. Parents are unable to transfer the loan to the student in the future.
Private Credit Student Loans
Banks, credit unions, and others make Private Credit Loans to those who pass the lender’s credit tests. These credit tests are often very similar to requirements that lenders impose on borrowers for mortgages, personal loans, and automobile loans.
Often, dependent undergraduate students do not have the necessary established credit track record in order to pass a lender’s credit test, but they may still get a Private Credit Loan. Nearly all Private Credit Loan lenders permit a co-signer to join the student as an obligor on a loan. In this way, the lenders consider the co-signer’s history and may extend a loan to the student and co-signer.
Important note: Both the student and the creditworthy co-signer are contractually obligated under the terms of the loan. If a student is unable to make payments, the co-signer needs to make the payment or they, too, will be reported as delinquent to the credit bureaus.
Many lenders also offer a co-signer release feature that permits the non-student co-signer to be removed from the loan once a student meets tests established by the lender.
Private Credit Loans:
- Require students to pass a credit test – often requiring undergraduates to apply with a co-signer
- Often permit the co-signer to be released from the loan when certain conditions are met.
- May offer fixed or variable rate loans with an interest rate that is dependent on the creditworthy borrower’s credit profile
- Rarely charge an Origination Fee
- Offer varying repayment periods, often between 7 and 15 years
- Have a maximum borrowing amount equal to the cost of attendance (minus other financial aid)
- DO NOT offer the same flexible repayment terms offered under the Federal Direct Loan Program
Undergraduate students have several options from which to choose the best loan to help them pay for college. The Federal Direct Program is designed to give students a limited amount of money to pay for college at a fixed rate of interest with favorable repayment terms. Other lenders offer Private Credit student loans which may supplement or be a substitute for Federal Direct Loans.
Families should understand the terms and conditions for each loan option and choose the loan which offers an optimal combination of terms and conditions for the student or parent borrower. For most families, the Federal Direct Program offers the combination that works the best.