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Consider When to Use Private Student Loans

Katy Hopkins

There are a few often-cited steps to take when it comes to borrowing for college. First, maximize all other sources you have to pay for college, including grants and scholarships, before even thinking about student loans, which will ultimately cost you more than the dollar amount you borrow.

Next, take as much as you can through federal loan programs, the most common lending vehicle used by students. Federal student loans include the Stafford, which comes with a low, fixed interest rate of 3.4 percent for undergraduates. To determine your eligibility for federal student loans, fill out the FAFSA and keep an eye out for loan awards in your financial aid packages.

[Avoid five assumptions about your financial aid award.]

But what happens if you still don't have enough money to pay for college? Take a step back to re-evaluate whether your college and major are the right choices for you--academically and financially. If so, consider your remaining options: the federal Parent PLUS loan and loans from private lenders.

"That is, I think, where this comparison is really key," says PK Parek, vice president of Student Loans for Discover Financial Services. "Both the PLUS loan and private loan can cover up to 100 percent of that gap in cost."

For eligible parents who are willing to take on debt for their student's education, Parent PLUS loans carry a fixed 7.9 percent interest rate and have a 4 percent origination fee. But the PLUS loans require a greater buy-in on the part of a student's parents, notes Joe Wilson, wealth management adviser at financial services organization TIAA-CREF.

"One of the major differences is the fact that a private student loan is taken out by the student, and the obligation to repay is the student's first, versus that PLUS loan, where, essentially, the parent is on the hook first," Wilson says. "Even if the student agrees to repay, especially if they renege on that agreement, the parent is still on the hook."

Conversely, students can get private loans on their own--though often only with a credit-worthy cosigner--and the loans may come with lower rates and fees. Options offered through Discover, for instance, come with fixed rates between 6.79 and 9.99 (depending on borrower and cosigner credit history) and have a 0 percent origination fee, Parek notes.

"Some lenders are really trying to point out in the current interest rate environment that, in many cases, private loans are actually cheaper," says Patrick Kandianis, cofounder of Simple Tuition, a company that helps borrowers evaluate their private student loan options, in addition to other services. "You're starting to hear more about the differences or the benefits of private borrowing in terms of the cost structure versus some of the federal options."

Though more private lenders have begun to offer fixed rate loan options, the majority of private loans available still have variable rates, which may look attractive but can be risky. Posted private loan interest rates could be as low as the 3.2 percent offered through Citibank, for example, but not every borrower will qualify for a rate that low. Plus, since it's variable, there is no guarantee that your interest rate won't spike before you've finished paying off your debt--ultimately costing you more.

And private loans with either fixed or variable rates have riskier repayment structures than federal loan programs. No student loan can be discharged in bankruptcy, but federal loan borrowers may be eligible for flexible repayment plans, such as Income-Based Repayment, which calibrates monthly charges to eligible borrowers' salaries, and Public Service Loan Forgiveness, which cancels any remaining debt for borrowers who have worked in the public sector for 10 years. Private loan borrowers, in comparison, do not automatically have the same protections or opportunities to cancel their debt.

[Read five common private student loan complaints.]

Still, some safeguards have been put in place for private student loan borrowers, and the Consumer Financial Protection Bureau has made recommendations for future student loan policy changes. Now, for instance, colleges have to certify that a student is borrowing a manageable amount of debt, even among loans from private lenders. "There's been a lot of work to try to make sure that people aren't just crazy borrowing," Kandianis notes.

Borrowers are ultimately in charge of the amount of debt they take on. Research into starting salaries and employers hiring grads from your school can help you project the likelihood of what you'll be able to pay, whether you're borrowing through a federal program or a private lender. A manageable student loan repayment will be about 10 percent of your monthly take-home pay after graduation, many experts recommend.

For any type of student loan, tell yourself this, Kandianis recommends: "I'm borrowing a whole bunch of money, and the only way I'm going to repay it is if I get out and get a good job ... Am I financing a throw-away or something sturdy that's going to be around for awhile?"

[Trying to fund your education? Get tips and more in the U.S. News Paying for College center.]

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