Federal vs Private Student Loans: Which Should You Choose?

Federal or Private Debt

If you have decided to attend college, you might need a student loan to cover part of the cost. There a number of different loan programs available, but your first decision is whether to obtain a federal student loan or a private student loan.

Although most students choose federal loans, there are times when a private student loan can be optimal. In fact, I had to make this exact decision a few years back and decided to obtain a private student loan instead of a federal loan for reasons discussed later in this article. Now that the loan is repaid in full, I can confidently say that I made the right decision.

The remainder of this article will explain your student loan options and offer some guidance on how to make this important decision.

Federal Student Loans

In past years, the federal government offered a multitude of different student loan options. This was problematic because the different rates, terms, and conditions led to much confusion among borrowers.

Today, everything has been simplified under the federal direct loan program. Under this new structure, the U.S. Department of Education provides three types of student loans directly to students, plus one additional loan option that is being phased out entirely.

1) Direct Subsidized Loans

Direct subsidized loans are available to undergraduate borrowers with financial need. Your FAFSA application and your chosen school determine your financial need and the amount that you can borrow each year.

If you qualify for a direct subsidized loan, you should take it. The U.S. government pays 100% of the loan interest during all of the following periods:

  • While you are enrolled in school at least half-time
  • Six months following your graduation (the grace period)
  • During a qualified period of deferment (discussed later)

When you no longer qualify for the interest subsidy, a subsidized loan will begin accruing interest like all other federal loans.

2) Direct Unsubsidized Loans

Direct unsubsidized loans are the most common type of federal loan, made available to undergraduate, graduate, and professional students. There is no requirement to demonstrate financial need to qualify, and your school determines the amount you can borrow based on the cost of attendance and other financial aid you receive.

Interest begins accruing as soon as an unsubsidized loan is disbursed into your financial aid account. You are not required to make payments while attending school (or during the 6 months following graduation), but all accrued interest will be capitalized (added to the principal amount of your loan), increasing the loan balance that must be repaid.

3) Direct PLUS Loans

The Direct PLUS loan program is available to the following individuals:

  • Graduate or professional students enrolled at least half-time at an eligible school
  • Parents (biological, adoptive, or in some cases, stepparent) of a dependent undergraduate student enrolled at least half-time at an eligible school

Unlike all other direct federal loans, PLUS loans require a hard credit inquiry. The borrower must have a clean credit report without any missed payments, bankruptcies, or delinquencies.

Because of the credit requirement, higher interest rate, excessive origination fee (discussed below), and lack of repayment options, I would recommend that you avoid PLUS loans whenever possible. For most borrowers, private student loans are a better option.

4) Perkins Loans

The Perkins loan program is available to undergraduate and graduate students with exceptional financial need. Under this program, the U.S. Department of Education supports colleges and universities who make and service each loan directly. The number of available loans depends on the financial aid budget of each school.

The federal government is shutting down the Perkins program. Qualified undergraduate borrowers can still obtain Perkins loans until 9/30/2017, but the program ended for graduate borrowers on 9/30/2016.

Federal Student Loan Interest Rates and Fees

Congress sets the interest rate on all federal loans, and rates can be changed once per year. Any rate changes apply to new loans only. Once you have obtained a federal loan, your interest rate is fixed for the life of your loan, regardless of future rate changes.

Federal student loans also carry an origination fee that cannot be avoided. This fee is a percentage of the loan amount and is deducted from each loan disbursement. For example, if you obtain a $10,000 direct unsubsidized loan, the $106.60 (1.066%) origination fee is deducted from the balance, leaving $9,893.40 in your financial aid account to spend.

Current interest rates and fees (loans disbursed between 7/1/2017 and 7/1/2018) are summarized below.

Loan TypeEligible BorrowersInterest RateOrigination Fee
Direct SubsidizedUndergraduate4.45%1.066%
Direct UnsubsidizedUndergraduate4.45%1.066%
Direct UnsubsidizedGraduate or Professional6%1.066%
Direct PLUSGraduate, Professional, or Parent of Undergraduate7%4.264%
PerkinsUndergraduate (ends 9/30/2017)5%0%

Obtaining a Federal Student Loan

To apply for any of the federal direct loans mentioned above, you must first complete and submit the Free Application for Federal Student Aid (FAFSA). Your school will use the information in your FAFSA form to determine which federal student loans you are eligible to receive. If you qualify, your financial aid package will detail the type of loan and dollar amount available.

If you accept a federal direct loan through your financial aid package, you will be assigned a loan servicer. These are generally private companies that handle all billing information, answer your questions, and send you monthly statements. Should you need it, the loan servicer will also work with you to navigate potential student loan repayment plans and loan consolidation.

If you forget anything related to your loan, you can log into the My Federal Student Aid website to review information about your federal student loans and find the contact information for your loan servicer.

Private Student Loans

A private student loan is any type of loan not offered through the federal government. Many banks, credit unions, and financial institutions offer these loans to the public.

Before choosing a private student loan, you need to understand several important details discussed below.

Interest Rates and Your Credit 

All federal student loans offer a fixed interest rate that is determined by Congress. Your credit profile doesn’t impact your ability to borrow (except PLUS loans, which should generally be avoided).

Private student loans usually allow you to choose a fixed or variable interest rate. As is the case with student loan refinancing, the rate that you are qualified to receive is determined by your credit profile. If you have outstanding credit, you will qualify for the lowest rates. If you have poor credit or very little existing credit (like most college students), many private lenders allow a co-signer on the loan application.

Several years ago, I had to decide between a federal direct unsubsidized loan at 6.8% interest and a private student loan offered by Discover Bank. At the time, I had very little existing credit, so the initial rates offered by Discover were around 5.5%. When my parents agreed to co-sign on the loan, the interest rate dropped to 3.25% (variable rate) because of their excellent credit. At that point, I chose Discover because the interest rate was far better than the federal loan option.

There are several important caveats. Not everyone will find a willing co-signer with excellent credit. Even though my parents trusted my ability to repay the loan, co-signing was a serious financial decision that required discussion and planning. Had I failed to repay my student loan, my parents would have been held legally responsible for the debt.

The bottom line is this – if you have great credit or a willing co-signer, private student loans can offer better rates than federal loans. If you have neither, private student loans rarely make sense.

Origination Fees

Unlike federal loans, most private student loans carry no origination fees. This difference was another major reason that I chose Discover instead of a federal direct loan.

Make no mistake, there is no benefit to paying origination fees. All of that money goes directly to the federal government or loan servicing companies.

Borrower Protections

While you are attending school, you are not required to make loan payments. After graduating, you will be required to make monthly payments until your debt is repaid. If you have difficulty making the required payments, there are specific protections in place that can be of assistance.

Federal loans offer the best protections, including income-based repayment plans and periods of deferment and forbearance. Private student loans do not qualify for any government repayment plans, but most offer deferment protections that cover illness, military service, public service, and professional residencies.

The biggest difference is that the government will continue paying the interest on subsidized student loans that are in deferment. Unsubsidized federal loans and private student loans continue accruing interest in deferment, which is added to the outstanding debt balance. Even though required monthly payments are paused, interest continues to accrue and capitalize.

Depending on your situation, these borrower protections might be important. You should keep this information in mind when comparing your private and federal loan options.

Obtaining a Private Student Loan

There are dozens of private student loan lenders, but it can take hours to submit an application to each lender. Using a student loan marketplace is a much better alternative, allowing you to compare dozens of lenders using one application.

Lendkey’s Marketplace features several hundred regional banks and credit unions. With one application, you can receive quotes from eligible community lenders offering the following benefits:

  • No Fees – No Lendkey partners charge any application, origination, or prepayment fees.
  • Cosigner Release – Creditworthy borrowers who have made consecutive, on-time loan payments are eligible for a cosigner release.
  • Community Focus – Regional lenders are typically more willing to help you to find a loan solution than large financial institutions.
  • Interest Rate Reduction – Receive a 0.25% interest rate reduction for establishing auto-payments.

Credible’s Marketplace allows you to compare large, established lenders in one place. With one application, you can receive loan quotes from Discover Bank, Citizen’s Bank, Sallie Mae, College Ave, Connext, and iHelp.

Much like Lendkey, Credible offers a number of borrower benefits:

  • No Fees – No Credible partners charge any application, origination, or prepayment fees.
  • Robust Support – Credible offers San Francisco-based support 7-days of the week, including 3-way phone support between you and lenders.
  • Cosigner Release – Creditworthy borrowers who have made consecutive, on-time loan payments are eligible for a cosigner release.
  • Interest Rate Reduction – Receive a 0.25% interest rate reduction for establishing auto-payments.

There is another benefit to using these marketplaces. The loan comparison is a soft credit inquiry, which means that you can compare dozens of lenders without harming your credit score. Only after choosing your preferred lender would you submit a complete loan application (which could result in a hard credit inquiry).

Federal vs Private Student Loans – Summary

If I were looking to obtain a student loan today, here is how I would approach the decision.

Undergraduate Students

Direct subsidized loans are almost impossible to beat. The 4.45% interest rate is competitive with the best private loans, but the borrower protections are far better.

Direct unsubsidized loans are still a very good option for undergraduates. The 4.45% interest rate remains the same, minus the interest subsidy.

If you have great credit or a willing co-signer, you can shop around for private student loans and try to beat the 4.45% rate. It’s definitely possible, but you also have to consider the repayment protections provided by federal loans.

Graduate/Professional Students

No subsidized federal loans are available for graduate or professional students. The unsubsidized graduate federal loan carries a 6% fixed interest rate plus a 1% origination fee.

Because graduate students are more likely to have a positive credit profile, private student loans can make sense. When I made this decision several years ago, I decided that the 3.25% loan offered by Discover was simply too good to refuse (compared to the 6.8% federal rate at the time). I gave up a few borrower protections to save a lot of money on interest – a decision that I would gladly make again.

If I were doing it again, I would use Lendkey and Credible to compare private student loan rates. Assuming I qualified for a rate lower than 6% (the federal loan option), I would then determine if the interest savings are more important than the repayment protections provided by federal loans. The wider the interest rate gap, the more I would favor a private student loan.

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