Private student loans rarely make financial sense
With interest rates on federal student loans set to rise for borrowers attending college in the 2022-23 academic year, it’s natural to wonder if you could get a cheaper loan rate elsewhere. . After all, private student loan companies still advertise variable rates as low as 1.19%, and even fixed rates as low as 3.49%. With these types of rates still available, you might be inclined to skip the FAFSA and opt for private loans instead.
That said, students and their parents should really think twice about taking out private student loans over federal loans, if at all.
The reality is that federal student loans have major benefits that you don’t get when borrowing from an independent lender. Additionally, private loans make borrowing, over-borrowing, and extra borrowing for college education much easier and can or maybe not even worth it in the end.
Although private student loans can be useful if you really need them to pay for your college education, they rarely make sense as a first choice. Here’s why.
Lack of access to difficulty options
First, you may know that interest rates have been set at 0% and payments have been suspended for federal student loans since March 2020. This emergency deferment period, which was triggered due to the pandemic, is currently set to expire on August 31, 2022. However, the emergency deferment can (and likely will) be extended again, meaning borrowers will likely have even more time with zero interest and no payment on federal student loans.
Like other forgiveness measures, including the regular deferment and forbearance options offered by the government, this temporary suspension of student loan payments only applies to federal loans — not private ones. In fact, borrowers with private student loans have been responsible for payments and interest since the start of the pandemic.
And although some private lenders offered short-term deferment and forbearance options, none of them included 0% interest, and none lasted for years like the federal break.
No loan forgiveness for private student loans
You may also have heard that President Biden plans to forgive some student loan debt for eligible borrowers through executive action in the coming months. The amount forgiven is rumored to be about $10,000 per person with student debt, which would completely eliminate loans for about a third of student borrowers nationwide.
However, there will likely be income caps on any student loan forgiveness plans that come to fruition, limiting who qualifies. Anyway, it is more important to note that any discount offered will only apply to federal student loans and not private loans.
Also note that most other student loan plans that incur a forgiveness only apply to federal loans. This includes teacher loan forgiveness programs, various state-based loan forgiveness programs for borrowers who work in the public service, and, of course, the Public Service Loan Forgiveness (PSLF).
Income-Based Repayment Applies to Federal Loans Only
Private student loans are also not eligible for income-driven repayment plans, which have become incredibly popular over the past few years. Income-based repayment plans like Pay As You Earn (PAYE) and Income Based Repayment (IBR) allow you to pay a percentage of your discretionary income for your loans for 20 to 25 years before forfeiting remaining balances. Very low-income borrowers may even owe monthly payments as low as $0 for their loans during the program.
It is important to be aware that amounts forgiven through this program are treated as taxable income in the year they are delivered, which may lead to a student loan forgiveness tax bomb (which is currently suspended until 2025 and can be extended). Either way, having private student loans means you are not eligible for income-based repayment at all.
Private loans facilitate excessive borrowing
Most federal student loans come with annual loan limits that cap the amount you can borrow for each school year. While these caps may force you to get creative with college funding, they will hopefully cause you to take steps you probably should take anyway — things like choosing a more affordable college, earning a secondary income to fill funding gaps at school and use the savings you have to pay tuition and university fees.
On the other hand, many private student loans don’t have the same caps, so they can make it easier to overspend. In fact, many private lenders will allow you to borrow up to 100% of certified school costs to attend college, minus other financial aid received.
Private loans require good credit
Another disadvantage of private student loans is that they usually require good or excellent credit, which college borrowers are unlikely to have. Without a good credit score, you’re more likely to pay higher interest rates than advertised by online student lenders.
Additionally, 90% of private loans end up having a co-signer – simply because the primary borrower (i.e. the student) does not have the credit to be approved on their own.
As such, there are risks involved in this approach. For example, your co-signer will be as responsible for the repayment as you are, which can lead to issues if you have trouble keeping up with your student loan repayments in the future.
Fortunately, most federal student loans don’t require a credit check, let alone an excellent credit score. The exception is Federal Parent PLUS loans and Federal Grad PLUS loans for graduate students, which require borrowers to have decent credit.
Variable rates make students vulnerable
Finally, borrowers should be aware that federal student loans come with fixed interest rates. This means that the interest rate on federal student loans will remain the same for the life of your loan, although you may have different federal loan rates for each year you attend college.
On the other hand, the lowest advertised rates on private student loans are usually for variable rate loan products. These variable interest rates fluctuate with market conditions, which can put students at risk when it comes to paying exorbitant rates in the future.
While it’s easy to apply for and receive private student loans, that doesn’t mean they’re the best fit for your budget or long-term financial goals. In fact, private student loans give you far less protection than federal student loans, and they can cost more.
Just because a private student loan offers a lower interest rate doesn’t mean it’s the best choice for paying for college.
Be sure to research all your options before borrowing for school, and know that there will be consequences – well or bad – for whatever you decide.