If you’re just starting college and exploring financial aid options, you’ll likely come across two types of loans, federal student loans and private student loans. It’s important to understand the difference between federal and private student loans because the terms of these loans—including when you start paying them back, the interest and initiation costs of the loans, and your options for repayment—will vary a great deal depending on the type of loan you take out.

What Is A Federal Student Loan?

Federal student loans are loans made to students by the U.S. Department of Education. Students who want to be eligible for federal student loans must complete the Free Application for Federal Student Aid, or FAFSA, to determine what types of financial aid they are qualified for. This might include grants or work study programs as well as loans.

Because they come with lower interest rates and more flexible repayment plans, many experts suggest students take out federal loans first and then use private loans to cover any outstanding balances.

What Is A Private Student Loan?

Private student loans are loans made from financial institutions like banks or credit unions. These are for-profit institutions that usually offer other types of loans such as mortgages, car loans, or small business loans. Just like with other loans, private lenders will do an evaluation to predict the likelihood a borrower will be able to repay what they borrow. The results of that evaluation then determine whether the borrower is given or denied the loan.

Institutions like these offer private student loans because the interest charges and fees from those loans make them money. This doesn’t mean that private lenders are bad, but they are pickier about who they lend to and are often less flexible about repayment plans.

How Do Federal And Private Lenders Determine Eligibility For Student Loans?

One big difference between federal and private student loans is who qualifies for each. Students applying for federal student loans are required to complete the Free Application for Federal Student Aid (FAFSA). This application provides the government with information about your financial situation, such as your income, investments, savings, and untaxed income (such as child support). They use this information to determine how much and what kinds of student aid you are eligible for. (Besides loans, you may be eligible for grants or work study programs that can offset the cost of college and do not need to be repaid.)

Although the FAFSA may exclude you from some types of financial aid, all applicants will be eligible for federal student loans as long as they meet certain criteria such as holding a valid Social Security number, being a citizen or eligible noncitizen, and having a high school diploma or equivalent. A full list of requirements for federal student loan eligibility can be found online.

On the other hand, financial institutions only make money from loans if borrowers can repay them, so private lenders are more selective about who they loan money. Typically, private lenders will want to see information such as a student’s credit score, credit history, income, employment history, and other debt. They may also want to know what the student plans to major in and the approximate cost of the school they will be attending. 

Often, students who are starting college right out of high school will not have much credit history, so private lenders might require them to find a cosigner. A cosigner is someone with a better or longer credit history who promises to repay the loan if the student cannot. Having a cosigner does not mean the student is not responsible for their loan. Rather, a cosigner is like an insurance policy for the lender in case extreme circumstances make it impossible for the student to repay their loan. Typically, parents cosign loans for younger college students.

How Do Federal And Private Student Loans Differ In Interest Charges?

Most lenders offer loans because the interest and fees they charge for the loan can earn them more money than they originally gave to the borrower. But the federal government is different from most lenders. While students are charged interest for their federal student loans, the interest rate tends to be much lower than what most private lenders offer. (In fact, some studies suggest the government might actually lose money on student loans.) Yet the government continues to offer student loans because society believes that people who attend college or trade school will be better equipped for the workforce and fill necessary jobs in society. In that sense, federal student loans are viewed as an investment in the country and its economy. Repayment of these loans helps to fund this program for future students.

In contrast, private lenders cannot continue making loans if those loans do not make a profit. For this reason, interest rates on private loans tend to be higher. For comparison, during the 2019-2020 school year, federal subsidized and unsubsidized loans for undergraduate students carried a fixed interest of 4.53%, whereas private student loans carried fixed interest rates between 4.29-12.49%. Private students loans with variable interest rates ranged from 1.8-14.18% during the same time.

What Limits Do Federal And Private Lenders Place On Borrowing?

Another important difference between federal and private student loans is that federal loan programs cap the amount of money a student can borrow. Limits for undergraduates are set based on the type of loan and year of study, with upperclassmen able to borrow more than underclassmen. Graduate and professional students are allowed to borrow more than undergraduates, but are restricted to fewer types of loans and an overall cap on borrowing for the combined cost of their undergraduate and graduate loans. The purpose of these caps is to protect the federal lending program as well as the borrowers. Students are discouraged from borrowing more than is necessary to cover their academic expenses since the more they borrow, the more they will owe and the longer it will take to pay back their loans.

Many private lenders also limit the amount students can borrow based on the cost of the school the student attends. However, not all lenders limit the amount students can borrow, which means students who aren’t thinking ahead may end up borrowing more than they need and taking longer to pay back their loans. In the long run, this can cost students much more in interest and fees than they had anticipated.

What Are The Differences Between Federal And Private Student Loan Repayment Plans?

There are a number of differences between federal and private student loans when it comes to repayment. For one thing, federal student loans are automatically set up for ten-year repayment plans, meaning if students make their minimum payments every month then they should finish repaying their loans within ten years of graduation. This is because the interest that students owe on the loan is rolled into that minimum payment, so each monthly payment pays on the principle of the loan as well as the interest accrued.

In contrast, some private lenders establish minimum payments that do not include the interest. That means that just making minimum payments does not guarantee that borrowers will pay off their loans. In fact, in cases where the interest rate is high, just making minimum payments on a private student loan can allow the borrower’s overall debt to increase.

Another distinction is that the federal student loan repayment plan builds in a six-month grace period immediately following graduation. During this time, students can find jobs and adjust to life outside of college. For younger students, this is an important time to adapt to independent living outside the safety net of their college campus.

While every private lender is different, most do not offer this grace period to borrowers. Students must begin making payments on their loan right away—assuming they have not been paying on their loan while attending school, which some lenders require.

Should I Use A Private Lender For My Student Loans?

Many experts encourage students to start by completing the FAFSA to see if they have financial aid options other than loans. Another important step is applying for scholarships through their school. Once these options have been exhausted, then students are encouraged to take out federal loans before relying on private loans. Generally, the lower costs and greater flexibility of federal loans makes them the better option for most students.

However, there are times when federal student loans are not an option or they do not fully cover the costs of attending college. This is increasingly common as the cost of college has risen sharply over the last few decades. In a situation like this, turning to a reputable private lender is a good option.

Although most private lenders are in the student loan business to make money, there are nonprofit lenders who make competitive, low-cost, private student loans for students. Interest and fees on these loans go back into the organization to help fund the next class of college-bound students, not into the pockets of the lenders. The goal of these institutions is to help make college accessible to deserving, high-achieving scholars.

Pickett & Hatcher is one of those institutions. If you’re considering private student loans to help fund your education, look no further than Pickett & Hatcher. We’ve been helping students afford the college of their dreams since 1938. Don’t let the high cost of college be a barrier to your education. Contact Pickett and Hatcher today and take the first step toward your future.