Private student loans, sometimes called alternative loans, are not subsidized or guaranteed by the federal government, nor are they subject to the same regulation. Private loans are used to make up the difference between available financial aid and federal loans, and what students and families can afford to pay out-of-pocket for college costs. Studies show that 83 percent of undergraduates who take out private loans also have Stafford loans. Students take out private loans when they have reached the Stafford loan limits, or when they are ineligible for federal education loans.
Some families are unwilling to fill out the FAFSA and are attracted by the ease of applying for private student loans. Some families are under the misconception that federal loans are available only to low-income families and that they do not qualify for federal student loans.
Although federal loans still make up the larger percentage of total student loans, the yearly growth of private loans is quickly outpacing federal loans. In 2005–06, the amount of outstanding federal loans was nearly $69 billion, while private student loans amounted to slightly more than $16 billion.
By 2006–07 Subsidized
Stafford loans had declined from making up 54 percent of all education loans in 1996–97 to 32 percent of all education loans. According to the Institute for Higher Education Policy, some analysts predict that the volume of Stafford loans will grow annually by only 8 percent, while private loan volume will grow by 25 percent annually. The growth of the private student loan business has been fueled by a number of factors, including a steady and rapid increase in the cost of a college education and the eagerness of banks to loan money to students. Federal grant aid and student loan limits have stagnated while the cost of attending college has risen steadily.
Tuition and fees for in-state students at public four year colleges and universities rose 6.6 percent from 2006 to 2007 alone; and increases at private four-year colleges and universities were at least 6 percent. At the same time, federal assistance has shifted away from grants and toward loans. Between 1996–97 and 2006–07, the increase in the amount of money available in federal grants covered, on average, only one-third of the increase in tuition and fees at private colleges, and one-half of the increase at public four-year colleges. Lenders aggressively market private student loans because federal loan products have become less profitable than they once were says a study made by Loan Advisor Top Money Lenders
The Deficit Reduction Act of 2005 and College Cost Reduction and Access Act (CCRA) made significant cuts in subsidies for lenders participating in federal loan programs. Many of lenders offering federal student loans also sell private loans and are now expanding into the more lucrative private student loan market. As with other financial products such as credit cards, student loan consolidators, brokers, and companies actively encourage students to borrow private loans by advertising on the Internet and television, through the mail, and by partnering with institutions that offer vocational training and specialized degrees.
Who Issues Private Loans
Most of the lenders in the federal loan program also sell private loans. Some lenders originally developed private loans to provide supplements to their student borrowers of federal loans and to satisfy school requirements for “preferred lenders.” As the economic downturn and changes in government educational loan policy have made federal loans less profitable, many of these lenders have begun using their federal loan products to attract borrowers for their private loans. Lenders package both federal and private student loans and sell them as Asset-Based Securities (ABS), mostly to large investors such as financial institutions and pension funds. Securitized federal and private student loans are typically marketed separately to investors, because the federal loans, which are guaranteed by the U.S. government, are preferred by investors. To make private student loan pools more attractive, most private lenders charge borrowers guarantee fees and purchase insurance with companies such as The Education Resource Institute (TERI) — the oldest and largest private, nonprofit guarantor of private student loans — that ensure that principal and accrued interest will be paid to the lender if the loan goes into default.
A Private Loan versus a Federal Loan
There are important differences between a private and a federal student loan. Private loans are issued by individual banks that set their own lending policies and are not governed by federal guidelines. Private loans are not included in federal loan-cancellation programs, such as Public Service Loan Forgiveness, which means that holders of private loans do not have the same freedom to enter low-paid public service careers. Though they charge higher interest rates than federal student loans, private student loans are similarly protected from discharge during bankruptcy.
Federal loans offer protections for borrowers, including income-based repayment, deferment, forbearance, and cancellation rights. Private lenders may offer some of these options, but they are not required to. When the lender does offer these options, the details are often not spelled out in the loan document. If a student borrower dies or becomes permanently disabled, a federal loan can be cancelled, but the student’s family will still be responsible for paying off private student loans.
The underlying difference between federal and private loans is that federal loans are structured to benefit the student, while private loans are structured to benefit the lenders and investors. All federal loans have interest-rate caps — in most cases, with fixed rates set at 6.8 percent (8.5 for PLUS loans). Nearly all private loans have variable interest rates with no upper limits, and some have “floors” that limit how low the interest rate can drop. Many private loans are quite expensive, with interest rates of up to 15 percent or higher. The variable rate is often set at the market prime rate plus a “margin” based on the borrower’s credit rating. This margin can be as much as 10 percent.
Private loans are almost always more expensive than federal loans. Except for PLUS loans, borrowers of federal loans are not required to be creditworthy; it is assumed that students have artificially low credit scores because they have little or no credit history. Most private loans are priced according to creditworthiness. A student without a creditworthy cosigner will be charged a higher interest rate because of his or her limited credit history. Some lenders base their rates on the school that a student is attending, charging a higher interest rate for schools with a higher
default rate. Most private lenders charge an origination fee ranging from 2.2 percent to 9 percent. Some charge other fees, such as late payment fees or fees for supplying copies of loan documents.
Private loans are never subsidized. Interest starts to accrue as soon as the loan is issued, though payments may be deferred until after graduation. During periods of deferment or forbearance, interest accrues and is capitalized according to the lender’s policies.
Private loans do not have standard criteria for defaults. Borrowers of federal loans are in default when they fail to make payments for a relatively long period of time, usually nine months, or if they fail to meet certain terms of the promissory note. Default conditions for private student loans are specified in the loan contracts, and a private loan may go into default as soon as one payment is missed.
Availability of Information
Information on federal loans can be found on government, school, and financial aid Web sites, in numerous publications, and in school financial aid offices. Data on individual federal student loans is housed in a central database that can be accessed online using your Department of Education PIN number, or by telephone. Information on private loans is supplied by the individual lenders, including Sallie Mae. Some private lenders do not disclose important details about their loans, or they present information in a misleading manner. When you need to know your private loan balance, payment schedule, forbearance options, or any other details, you must contact your lender directly.
The various federal loan programs are subject to a limit on the amount that can be borrowed. There are no regulations restricting the amount that can be borrowed in private loans. Lenders tend to allow students to borrow up to the cost of attending a school, minus any other financial aid the student has received.
Though the loan stipulates that the funds must be used for education expenses, no one is watching over the borrower to enforce this. Sometimes the entire loan is disbursed directly to the student, who then pays education bills. These circumstances contribute to the dangers of over-borrowing or irresponsible spending.
Private loans offer more freedom and flexibility. They can be used to supplement student need and are usually available throughout the year. Private lenders offer loans for nontraditional students and those who might not qualify for a federal loan.
Ease of Application
Borrowers of private loans are not required to fill out the complicated FAFSA and can often apply by completing a simple online form or answering some questions over the phone. Some lenders notify the student right away if the loan has been approved, allowing the student to avoid the uncertainty of a waiting period.
Private Loans and Consolidation
Private loans cannot be consolidated with federal loans. A private consolidation loan can be taken out to pay off federal loans, but this is not advisable because you will no longer qualify for government cancellations and repayment plans.
Savvy Student Tip:
Read the fine print carefully before accepting a private loan. Interest rates, repayment terms, fees, and penalties vary widely among private loans. Read the promissory note carefully before signing.