How Do Private Student Loans Work?

There’s a great deal of variety in the world of student loans, especially when it comes to exploring private loans to pay for your education.

Variety can be intimidating, but it’s also great for the consumer, since the more you know, the more you can benefit from loans that are a great match for your personal situation. Intrigued?

As a writer for a financial services technology startup that offers low-rate student loans for grad students, I’m here to walk you through the basics of private education loans: what private lending is, what your options are, and the costs and benefits associated with different loans.

What makes private loans different from other types of student loans?

There are two types of student loans: federal loans, offered through the U.S. government; and private student loans, offered primarily through banks. Both are governed by specific rules under the tax code (such as laws pertaining to bankruptcy) that make student loans from either source distinct from other types of loans.

The key difference between the two is that federal loans are borrowed through the U. S. Department of Education and are, thus, subject to federal regulation, while private lenders determine the rules that govern their loans. For borrowers who aren’t sure whether federal or private student loans are a good fit, a common rule of thumb is that federal loans come with strong borrower protections (more on that later), while private loans may come with lower interest rates that can offer more savings in the long run.

Where can you look for a private loan?

There are many technicalities regarding which financial institutions can act as lenders (especially between states), but you can generally borrow from institutions like national or community banks, credit unions, and startups. You may recognize some of the biggest names in private loans, such as Sallie Mae, while startups like CommonBond have been in the student loan space for just a few years.

Why would you consider a federal over a private loan, or vice versa?

Private lenders don’t typically offer the range of repayment options that are available to federal student loans borrowers, such as the Income-Based Repayment option allowing students to make payments based on their income and family size. Moreover, federal loans may come with forgiveness programs for graduates who enter certain fields or agree to work in certain communities for a specified period of time. These plans offer flexibility in the event that you need a lower monthly payment or enter a period of hardship that makes repaying your loan a significant hardship.

The government also offers basic borrower protections, such as deferment (delaying the payment of your loan without interest accruing) and forbearance (delaying or reducing loan payments while interest continues accruing); many private lenders do not. (Ask any private lender you’re considering about the specific protections they offer). The government, on the other hand, offers the same interest rates on its loans to all of its borrowers. The result is that if you have great credit and great job prospects, you’re probably not getting the best deal with federal options because a private lender may factor in these qualities and offer you a lower interest rate.

Private lenders base their rates on how likely you are to repay your loan, a calculation they arrive at based on their own loan underwriting criteria and your personal credit history. This means that many borrowers could get lower interest rates on private student loans than on federal student loans; and of course, lower interest rates mean paying less in interest over the life of the loan, helping you save on the total cost of your education.

Moreover, private loans come in many shapes and sizes, including not only fixed interest rates (like the government has), but also variable rates or hybrid, fixed-to-variable rates (that the government doesn’t offer), any of which may be a better choice depending on your personal situation.

How do I apply for a loan?

If you’re not sure whether federal or private loans are the best fit for you yet, you can apply for both. You can file the FAFSA, the Free Application for Federal Student Aid, online or by mail in order to assess whether you qualify for federal loan programs. Don’t wait until the end of the summer to file this, but do wait until after you finish your federal tax returns. (That way, there’s less of a chance of accidentally misreporting your earnings and other financial information; the FAFSA includes a free data retrieval tool to help you fill out the form using data the IRS already has on file.)

You can apply for private student loans by going to different lenders’ websites and completing their individual applications. Watch your timing carefully, however, and submit those applications close together. Why? Filing the FAFSA does not affect your credit score, but applying for private loans does — each private loan application results in a hard credit inquiry, which can have a negative short-term effect on your credit. Luckily, if you’re looking for the same type of student loan but are applying to several private lenders, your credit will only report one hard inquiry if you make all your applications within 30 days. (Here’s more on how FICO views rate shopping when it comes to your credit score and student loans.)

When it comes to private loans, the most important task before signing up is to understand both the potential savings and the level of service you’ll get from your lender, especially when you have questions. If you’re not sure, get in touch with your lender and speak to a representative who is helpful and knowledgeable — it’s a great test of the service you could get if you become a borrower — and be sure you understand everything in writing before you sign. Do research, ask friends or classmates about the experiences they’ve had, or speak to independent financial planners for recommendations.

And if you have any questions about student loans in general, we’re happy to help; just email us at [email protected] or leave a comment below — we’d love to hear from you!