Private Student Loans vs. Federal Loans

The Project on Student Debt recently reported that the percentage of undergraduate college students who took out private (non-federal) student loans shot up from 5% in 2003-2004 to 14% in 2007-2008. This large increase attracted the attention of student advocates because private student loans typically have much higher interest rates and less favorable borrower terms than federal student loans.

Federal student loans include Perkins loans, subsidized and unsubsidized Stafford loans, and PLUS loans for parents and graduate students. Private student loans are loans offered by banks, financial institutions, and companies that specialize in student loans, such as the Student Loan Marketing Association (SLM, or “Sallie Mae”).

There are a number of myths that persist when it comes to understanding private student loans vs. federal loans, including federal loan eligibility. While it’s true that federal Perkins loans and subsidized Stafford loans are income-restricted, unsubsidized Stafford loans are not: almost all students – and certainly far more than the number of students who apply for them – are eligible for unsubsidized Stafford loans.

Also, there is plenty of federal funding to go around. In the 2007-2008 school year, the U.S. Department of Education provided nearly 10 million students with approximately $100 billion in federal financial aid, and with the dollars the Obama administration has just added to the education budget, that funding is likely to be the same again, or higher, this year. It’s not yet clear how much private funding will be available for private student loans, with financial institutions still working on recovering from the 2007-2008 credit crisis.

A low, fixed interest rate is one of the primary advantages of federal student loans in the private student loans vs. federal loans debate. A fixed interest rate is one that stays the same for the life of the loan, regardless of how banking interest rates may fluctuate. Currently, the interest rates on new subsidized Stafford loans is 6.0%; on new unsubsidized Stafford loans, 6.8%; on Perkins loans, 5.0%; and on PLUS loans for both grad students and parents, either 7.9% for a loan taken out through the Direct Lending program or 8.5% for a loan taken out through the FFEL program.

In contrast, the current interest rate of the average private loan is about 12%, according to Mark Kantrowitz, publisher of FinAid.org, who was quoted in a Forbes.com article dated April 22, 2009. Additionally, most private student loans have a variable interest rate, not a fixed rate. A variable interest rate is one that may not stay the same for the life of the loan: your private loan’s interest rate may go down, but it may also go up.

One likely reason why the percentage of college students taking out private student loans has increased is the huge increase in tuition at most colleges. Sometimes, depending on the school you want to attend, a private loan may be unavoidable to cover the gap between the true cost of attendance and what federal student financial aid will cover. In this case, college financial aid advocates remind students of two old and well-known pieces of advice: shop around and read the fine print.

But advocates also urge students to fill out the FAFSA and take maximum advantage of federal student loans before signing the dotted line on any private student loan. Go after federal, state, and private scholarships, too. It may be that a Pell Grant (which you’ll get automatically if your FAFSA qualifies you for one) and scholarships from multiple sources will help you bridge the college cost gap without need of a private loan.

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