There’s a great divide in the world of student loans: federal versus private. If you apply for financial aid when you enroll at a college, university, or technical school, student loans will probably be part of your financial aid package. Federal student loans are made by the federal government, and private student loans are made by private lenders such as banks, credit unions, or sometimes the schools themselves. There are quite a few important differences between federal loans and private ones.
One of the biggest differences between a federal and private student loan is the credit requirement. Most federal student loans don’t require a credit check, which is a big deal to borrowers because many are young and haven’t built up a long credit history or a good credit score yet. And older borrowers with bad credit can still receive most types of federal student loans.
The exception is the PLUS loan program, which is a type of loan available to graduate students and to parents of students. The PLUS loan program does require a credit check, and adverse credit reporting can cause the applicant to be denied. Private loans will always require a credit check and, generally speaking, good or excellent credit is typically required. Borrowers with little credit history or bad credit scores often need cosigners in order to qualify for private student loans. In addition to evaluating a borrower’s creditworthiness, some private lenders have minimum income requirements.
Federal loans have relatively low, fixed interest rates that are usually lower than the rates available from private lenders. For the 2016-2017 academic year, federal student loan rates were offered between 3.76% and 6.31%, with the lower rates available to undergraduate students and the higher rates available to graduate and parent borrowers. However, some very well-qualified borrowers can get more attractive rates by applying with private lenders.
Many undergraduate borrowers can receive subsidized Stafford Loans from the federal government, up to a yearly limit. In that case the government pays for their loan interest as long as they are enrolled at least half-time in school. Private student loans never have this option, and interest will either be capitalized while the borrower is in school or the borrower will need to make monthly payments of principal plus interest that start before graduation.
The number one reason borrowers default on their student loans is because the monthly payment is more than they can comfortably afford to make. With private loans, there is rarely any leeway to modify a monthly payment unless the borrower can refinance to a longer term with the same or different lender. However, the government offers a wide variety of repayment options for federal student loans, and these are available to almost every borrower (the exception being Parent PLUS loans).
In addition to the standard ten year repayment option, there are a number of extended options up to twenty-five years. The best part is, most of these extended repayment options will also allow the borrower to limit their monthly payment to just ten to fifteen percent of their monthly discretionary income. The repayment plans that offer this limited monthly payment are called Income-Driven Repayment Plans, and there are several types available to choose from.
Deferment and Forgiveness
The final big differences are regarding availability of deferment and loan forgiveness. In this category, federal loans unquestionably beat private loans. With federal loans, repayment is automatically deferred anytime the borrower is enrolled in school at least half-time. Some private lenders, but not all, also offer deferment while in school. With federal loans, deferment is available during times of extreme economic hardship, such as during job loss or chronic illness, although there are time limits on how long a borrower can defer their payments. Private loans generally don’t offer any out-of-school deferment. And, federal loans offer borrowers loan forgiveness in several situations.
Borrowers taking advantage of the Public Service Loan Forgiveness Program or Teacher Loan Forgiveness can have their loans forgiven after just ten years, while others can get loan forgiveness after twenty or twenty-five years on an Income-Driven Repayment Plan. If a borrower dies before they’ve repaid all of their loans, the federal government forgives the loans as a matter of policy. In contrast, private lenders don’t offer any loan forgiveness while the borrower is alive, and often force a borrower’s estate or cosigner to repay the loan even after a borrower’s death. In short, federal student loans are much more forgiving in their terms than private ones.