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What is the difference between federal and private student loans?

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There are several important differences between federal student loans and private student loans.

Namely, the important differences deal with cost, repayment, accessibility, and permitted uses of funds.

Cost is usually most important to the majority of borrowers and is an excellent starting point to showcase the differences between federal and private student loans.

The Cost of Federal and Private Student Loans

The cost of private student loans is really dependent on credit requirements. Since private student loans come from banks, credit unions, and online lenders, credit requirements can vary wildly.

Applicants with low credit scores can expect to get costly quotes while those with good to great credit scores can expect to enjoy the lowest of private student loan interest rates.

This is because applicants with low credit scores are risky for lenders to give money to. Their credit scores reflect a history of missed or late payments and the cost of that history results in more expensive financing.

Private student interest rates can vary wildly from 2 percent to 18 percent depending on the lender, the borrower’s credit, and the presence (or lack thereof) of a co-signer. 

The cost of federal student loans are more set in stone.

The interest rates on federal student loans are not dependent on a borrower’s credit score or perceived  risk. Rather, the government sets interest rates for federal student loans and borrowers have to take them at that price.

Jan Miller, President and Founder of Miller Student Loan Consulting, said that the repayment rules for federal student loans are also fixed.

“In other words, the lender has very little discretionary control over how to manage policy on the loans,” she said. “For example, the loan agreement (promissory note) and interest rate are both governed by the federal government. As a result, borrowers are subject to the same handling of the loans, no matter who their lender or servicer is, in regards to the repayment options.”

But with private student loans, the details, terms, and benefits vary on a lender-by-lender basis.

For instance, when working with the private student loans offered at Wells Fargo and Discover, Miller noticed some very important repayment differences.

“Discover Financial offers up to 1 year of forbearance, in 6-month increments,” she said. “Wells Fargo usually only offers 2 months of forbearance.”

She found that Wells Fargo offers fewer overall benefits than Discover Financial, another sign that private lenders vary drastically.

“Wells Fargo handles their private student loans very similarly to a bank loan with very little repayment options for borrowers,” she said. “Discover offers more options for borrowers who are having financial difficulty paying back their private student loans.”

Further underscoring just how varied private lenders can be are their different approaches to customer service. While customer service can be easily overlooked, it is very important should a borrower notice a mistaken payment or other error.

“Larger lenders, such as the Direct Loans or Sallie Mae, will often have better training for their representatives,” said Miller. “They may also be easier to get a hold of. Others may not, and be of little help if you do get them on the phone.”

Even if a borrower falls past the point of no-return and into default, student loans can still be costly even if no payments have been made for months or years. This is because student loans, both federal and private, are almost impossible to get discharged via bankruptcy.

“For defaulted private student loan borrowers, many lending institutions will send the loan directly to a standard collection agency immediately after default,” said Miller. “The standard rate of default with most private student loan lenders is at 120 days of delinquency.”

But there’s one place in which private student loan borrowers are afforded more protection than their federal counterparts: ease of wage garnishment. The federal government has the power to use debt collectors to garnish wages without filing judgment in court. As one can imagine, garnished wages can prove extremely costly to a federal student loan borrower.

“This is why over 80 percent of all debt on defaulted federal student loans is recouped by the government,” said Miller. “Private student lenders do not have this luxury. They must file judgment on the borrower and take them to court, like with any other type of debt, before they can force the borrower to pay back the loan.”

Who Can Borrow Federal and Private Student Loans?

Oliver McGee, Professor of Mechanical Engineering and Former Vice President for Research Compliance at Howard University, said that private loans are mostly available to students through Sallie Mae and some private banks. These loans are mainly designed to supplement federal student loans and not act as the sole source of money for college.

Federal student loans are instead made available through the government, which handles the application and approval process. Federal student loan borrowers can determine their eligibility for student loans through completion and submission of a FAFSA.

FAFSA applications help financial aid offices gain a full picture of an applicant’s family or personal income. This allows the financial aid offices to determine what kind of federal student loans a prospective borrower qualifies for, such as for fixed- or variable-interest financing.

Private student loans are instead available to most anyone who can qualify for them. However, they are mainly for students who have exhausted their federal student loans and need additional college funds. In effect, private student loans help borrowers make up the difference between the money they got from the government and whatever amount is needed for tuition, lodgings, and cost of living. 

Since graduate students can’t borrow as much money as they did when they were undergrads, many turn to private student loans once they have borrowed as much federal student loans as possible. As a result, most private student loan borrowers tend to be graduate students since federal student loans for graduates are both smaller and more expensive compared to undergrad loans.

Which Loan is Better?

Clearly, both types of student loans are different. But different doesn’t necessarily mean one is better than the other.

Private student loans tend to be more expensive than federal student loans, but this isn’t the case for everyone since people with excellent credit scores are likely to get generous terms on their private financing.

Federal student loans are more readily available than their private counterparts, but they can be difficult to repay as the Student Debt Crisis shows.

Still, private student loans lack the many benefits of federal student loans, such as easier and longer deferments, forbearance, and consolidation options. Even though these may be unimportant to a recent graduate who thinks they will land a dream job, they can be very important if a borrower falls on hard times.

“Federal student loans should always be the first option for students and their families,” said Patrick Kandianis, Co-Founder and EVP of SimpleTuition. “They generally have lower, fixed interest rates and are sometimes subsidized so they don’t accrue interest while the student is enrolled.”

With federal student loans out of the way as a first option, only then should borrowers and their families look into private student loans. While private student loans can mean the difference between being able to and being unable to attend college, they should still be approached with a measure of caution and awareness.

“College is expensive, and with tuition rates rising faster than the rate of inflation, it is only going to continue to get more expensive,” said Kandianis. “For students and parents who are planning how to pay for college, that means that making smart borrowing decisions is more important than ever.”

By being smart about college financing and understanding upfront how much money they will need to borrow, students can calculate and plan for their years of repayment. Having awareness about the different types of student loans lets borrowers avoid being overwhelmed by debt in their long lives after college.