Federal loans are usually a better bet for students than private ones, but that doesn’t mean there aren’t exceptions.Image source: Getty Images.
Many students have no choice but to borrow money for college when they or their families don’t have the funds on hand to pay those costs in full. You have two choices for taking out student loans: You can borrow money from the U.S. Department of Education via a federal loan, or you can borrow privately from a bank, credit union, or online lender.
Generally speaking, students are advised to favor federal loans over private loans. That’s because federal loans come with terms and protections that are better for borrowers. Still, there are some cases when it makes sense to take out private loans.
The benefits of federal loans
The higher the interest rate that’s attached to your loan, the more money it’s going to cost you. One major advantage of federal loans is that their interest rates are fixed and capped. Private loans, on the other hand, can charge whatever interest they’d like, and because many come with variable interest rates, students who borrow privately are often subject to unpredictable monthly payments after graduation.
Furthermore, federal loans are often subsidized so that interest doesn't accrue on your loans during your studies (rather, the government takes care of it). Private loans aren’t subsidized, so once you take one out, interest begins accruing on your principal, even while you’re in school.
Federal loans also come with a number of important borrower protections that can make managing and repaying that debt easier. For example, if you take out federal loans, you can apply for an income-driven repayment plan if you find that you’re unable to keep up with your monthly payments under the original terms of your loan. At that point, your payments will be recalculated as a percentage of your income. Federal loans also offer some borrowers the option to defer payments temporarily, or even apply for loan forgiveness.
Private loans, on the other hand, generally don’t have these provisions, though it’s definitely worth noting that some lenders might work with you if you reach out and ask for better terms or leeway. For example, if you borrow privately and struggle to make your monthly payments, your lender might agree to reduce them. Similarly, some private lenders will allow you to defer payments for a period of time, but you might face a fee for this privilege. And you can almost certainly count on accruing interest during your deferment period, whereas with a federal loan, that may not happen.
Finally, federal student loans are need-based, and good credit isn’t required to qualify. Private lenders do require good credit, and if you don’t have it, which may be the case if you’ve yet to establish a credit history, you’ll need to enlist the help of a cosigner to get the financing you need.
When private student loans make sense
Most of the time, you’re better off taking out federal loans to pay for college. But keep in mind that some private lenders offer very competitive rates for borrowers with great credit, in which case you could end up scoring a lower interest rate than you’d get with a federal loan. The same holds true if you’re pairing up with a cosigner who has excellent credit.
Furthermore, as mentioned earlier, private student loans often have variable interest rates. This can be a bad thing once those rates climb, but if you start out with a low interest rate and pay down your debt quickly, you could wind up paying less interest than you'd pay for a federal loan.
Also, private loans don’t have a borrowing cap, which means you can take out as much money as you need for college. Federal loans come with borrowing limits, and as such, they may not provide all of the financing you need to cover the cost of your education.
Let’s be clear: It almost always pays to max out your federal loan options before taking out private loans. But if you do get stuck borrowing privately in some shape or form, all is not necessarily lost.
The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.