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Federal vs. Private Student Loans: Which Should I Choose?

Elizabeth Aldrich, The Motley Fool

Whether you’ve got student loans or you plan on applying for them, understanding the difference in types could save you thousands. Image source: Getty Images.

Piggy bank with graduation cap on pile of money

There are currently 44.5 million student loan borrowers in the United States. Together, these borrowers owe $1.5 trillion.

Roughly $1.4 trillion of that is owed to the U.S. government in the form of federal student loans. The rest is private student loans. So, what’s the difference?

Federal vs. private student loans

The basic difference between federal and private student loans is that federal student loans are offered by the government, while private student loans are offered by a private-sector lender. These two types of loans offer very different benefits, interest rates, and repayment options.

Loan type

Average interest rate

Does my credit matter?

Are they subsidized?

Are there income driven repayment plans?

Can my loans be forgiven?

Federal student loans

4.45% for undergraduates, fixed, 6% for graduates, fixed

No

Sometimes

Yes

Yes, if you qualify

Private student loans

7.99%, usually variable

Yes

No

No

No


What are the benefits of federal student loans?

Federal loans have fixed interest rates, so the interest stays the same until you finish paying off the loan, regardless of how the market rises and falls. Currently, federal student loan interest rates are fixed at 4.45% for undergraduate students and 6% for graduate students.

Some federal loans are also subsidized. Subsidized loans are ideal because the government pays the interest for you while you are in school or deferment. On the other hand, unsubsidized loans begin accruing interest as soon as they are taken out.

Loan feature

With partial subsidized loans

Without any subsidized loans

Subsidized loans

$12,000

$0

Unsubsidized loans

$8,000

$20,000

Initial balance

$20,000

$20,000

Balance upon graduating

$21,424

$23,562

Data source: Author's calculations.

As you can see, federally subsidized loans can save students thousands of dollars before they even graduate.

Once you have graduated, federal student loans will afford you more accommodating repayment options. If you are unable to make your payments, you have the options of deferment and forbearance, allowing you to temporarily stop making payments. If you have subsidized loans, they will not accrue interest during deferment.

Federal student loans also offer a variety of repayment plans, including an income-driven repayment plan for people who cannot afford high monthly payments. You may even qualify for one of a number of loan forgiveness programs offered by the federal government.

What are the benefits of private student loans?

Private student loans are offered by banks, credit unions, state loan programs, and non-federal institutions. Everything from a Sallie Mae loan to a loan offered by your university is considered a private loan. There are two main benefits to private student loans.

  • You may qualify for a higher borrowing limit
  • You may qualify for a lower interest rate if you have excellent credit

Unlike subsidized federal loans, private student loans are not need-based. You can qualify for a higher loan amount, especially if you have a co-signer with good credit. For this reason, private student loans are commonly used as a supplement when federal loans don’t cover a student’s financial gap.

While private student loans have a higher interest rate on average, it is possible to get a private student loan with an interest rate as low as 3% or 3.5% if you have excellent credit. People who are able to qualify for these low rates may choose private over federal student loans.

However, it’s important to remember the drawbacks of private student loans. Many come with a variable interest rate. This means that it can increase as the federal interest rate increases, which it has been doing since 2015. None are subsidized, so interest will start accruing when you take out the loan.

You also want to consider the fact that private student loans offer less flexibility in terms of repayment. You cannot get your private student loans forgiven, and you are not eligible for an income-driven repayment plan. On top of that, some private student loans even require you to start making payments while you’re still in school.

Which one is right for you?

Subsidized federal loans are a no brainer, and if you qualify for them, they should be your first option. After that, it’s generally a good idea to turn to unsubsidized federal loans.

If you’ve maxed out the federal student loans available to you and you still can’t afford to cover the costs of your schooling, then it might be appropriate to start applying for private student loans. Private student loans should be used to supplement rather than replace federal student loans.

The only exception to this rule would be if you have excellent credit and are able to qualify for a private student loan with a significantly lower interest rate. Even if you do find a very low interest private student loan, you will also want to consider the following factors:

  • Is the interest fixed or variable?
  • Do you have to start making payments while you’re in school or can you wait until you graduate?
  • Does the lender offer any loan deferment options?
  • Can you make pre-payments without paying a penalty?

Ultimately, the repayment terms are just as important as the interest rate. Unless you have a guaranteed source of income, it’s important to prepare for the possibility that you might not be able to make your loan payments once you graduate. Federal student loans offer protection under those circumstances, which is why most students opt for them over private student loans.

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