What is a private student loan and its pros and cons?

Funding a college education can be a challenge for many student loan borrowers, with annual costs exceeding $26,000, according to the Education Data Initiative. When grants, scholarships, and federal student loans aren't enough, private student loans can help make up the difference.

Funded by banks and private lenders, private school loans can help cover expenses such as tuition and fees, housing, books, and supplies. Lenders set their own eligibility criteria, and interest rates are usually based on the creditworthiness of the borrower. While private loans are a useful tool for some people, they are not the best option for everyone. Before getting a loan, review the pros and cons of this type of loan.

Loan amount

One of the advantages of private student loans is that many lenders allow you to borrow up to the full cost of your education. However, this policy varies depending on the lender, your credit score, your jurisdiction, and whether you have a co-signer.

Some lenders set the total loan amount with a lifetime loan limit, which may depend on the private student loan you're applying for. For example, with Citizens Bank, undergraduates and most graduates can borrow a total of $150,000 in student loans. This limit increases to $225,000 for MBA and Law degrees and $250,000 for healthcare degrees.

Payment options

Many private student loan borrowers have a grace period similar to federal student loans, which is six months after graduation, or fall below part-time or school dropout status. They also have different repayment terms, often ranging from five to 20 years.

Some lenders are more flexible than others when it comes to repayment schedules. For example, College Ave allows college borrowers to choose five, eight, 10, or 15-year repayment terms, while Discover only offers 15 years.

You can usually refinance your loans after graduation. This can be a good option if you don't like your payment plan and want to secure a lower monthly payment or a different payment schedule.

Eligibility requirements

All lenders have internal guidelines on which borrowers they accept and which ones get the lowest rates of interest. In general, lenders are usually looking for:

Good Credit: The better your credit score, the more likely you are to qualify for a private student loan at the lowest interest rate available. If you have a very low credit score, you may need a co-signer.

High Income: Lenders want to know if you can easily pay off your student debts. You or your co-signer must prove that you have a stable income to pay off your student loans.

Low Debt-to-Income Ratio: Lenders will be more reluctant to lend to you if you have a high debt-to-income ratio. Try to keep your debt-to-income ratio below 50 percent.

Citizenship: Many lenders require that you be at least 18 years old and have a US citizenship. International students qualify with some lenders as long as they have a US citizen co-signer on their loans.

Eligible Schools or Programs: Lenders may check your school to confirm your enrollment, and some only work with certain schools. They will also check the total cost of attendance minus other assistance to ensure that you are not borrowing more than you are entitled to. You may not qualify for private student loans if you are not enrolled in or accepted into an eligible program.

Interest rate

Federal student loans set interest rates before each school year, and all borrowers who apply in a given school year receive the same flat rate of interest. On the other hand, private lenders are free to set limits on interest rates and change these rates regularly. The interest rate depends on several factors, including your credit score, loan amount, and chosen repayment period. Private student loan rates usually range from about 1 percent to 14 percent.

Borrowers with private loans typically have the option of choosing between a fixed and variable interest rate. The initial interest rates for fixed rate loans are usually higher than variable rate loans. However, if you choose a fixed rate, the price you get when you take out your loan is the price you will pay for the term. If you choose a variable rate, the rate you receive may change regularly, which can make your loan more expensive over time.

Benefits & Drawbacks of Private Student Loans

Private student loans have many advantages, but the downside must also be considered before enrolling.

Pros

A large amount of debt. Federal student loans have annual limits that can be as high as $5,500 for undergraduates. After you max out your federal student loans, you may need funds for additional expenses. Private student loans can help bridge the gap.

Fast application process. While federal student loan borrowers are required to fill out the Free Application for Federal Student Aid (FAFSA), private student loans do not. You can apply for most private student loans online in just a few minutes without providing a lot of information.

Available to college students part-time. You must be in school at least half the time to qualify for federal loans, but some private lenders will allow you to borrow money if you attend school less than that.

Competitive interest rates. Student loan interest rates and loan terms can be incredibly generous for borrowers with excellent credit or a qualified cosigner. If you want to pay the least amount of interest on your student loans, private student loans may be the best option.

Cons

Short payment schedules. Private student loans come with shorter repayment schedules than federal loans. With some government programs, you can adjust your student loan payments for up to 25 or 30 years, while most private student loans have a 15-year limit for undergraduates.

There is no government-sponsored public service or teacher loan forgiveness. Programs such as Public Service Loan Forgiveness (PSLF) are not available for private loans. In general, there are a few methods for private loan forgiveness.

There is no income-based payment plan. Some federal student loans can be repaid on income-based repayment plans, which adjust your monthly payments based on your income. Private student loans usually only have traditional repayment options.

There is no delay or restraint from the government. While some of their student loans are tough options if you're having trouble making payments, these programs aren't as robust as those offered by federal loans.

When should you think about obtaining a private student loan?

Most experts recommend maximizing your federal student loans before switching to private student loans. Thus, you'll have access to income-based repayment plans, loan forgiveness programs, and extended deferral and forbearance periods.

If you still need money for tuition or other expenses, consider private student loans. And only borrow what you need. The more you borrow now, the more you'll pay after graduation.

Other situations in which private loans are appropriate include:

Your expenses suddenly change. If you've exceeded your federal student loans and your tuition expenditures are suddenly increasing, private student loans can help you get more money faster.

You do not qualify for federal loans. International students may not be qualified for federal loans, so private loans may be the only way to fund them.

You have a specific plan to pay back the money you borrowed in a short period of time. If you plan to pay off your student loans over a few years, private student loans may be cheaper overall.

How to choose the best private student loan

It is important to shop around before deciding on a lender. In other words, take the time to compare loan options from several lenders. Don't go with the first private student loan company you come across. Here's how to choose the best:

Decide between a fixed and a variable rate. Many private lenders offer the choice between a fixed and variable rate, but some offer only one or the other. Consider your preferences beforehand so you know what to look for.

Compare interest rates. The interest rate determines how much the total cost of your student loan will be. Compare interest rates among different private lenders to find the lowest. Take advantage of pre-qualification offers so you can see what rate you qualify for without having to do a thorough check of your credit report.

Apply for the appropriate loan for your degree. Some student loans are offered to students in specific programs. For example, if you are pursuing an MBA or plan to attend medical school or dental school, you will want to look into specific private loan programs.

Research each lender's reputation. The lender's reputation is just as important as the interest rate when it comes to applying for a private student loan. There are many reputable third parties you can use when looking at lender ratings, such as the Better Business Bureau (BBB).

Browse benefits. Some lenders offer special benefits, such as no late fees or longer grace periods. Some may offer programs that make payments easier after graduation.

Make sure the lender accepts your school. While a lender may look good on paper, some may have a specific list of accredited schools. You may check the lender's website or call to discover whether your school is eligible.

Private student loans and loan forgiveness

Private student loan forgiveness programs are not offered in the same way as federal loans. Private student loans are only forgiven if the borrower dies or becomes permanently handicapped.

Many private student lenders provide hardship aid programs; however, eligibility varies depending on the lender and circumstances. There are no standards among all private student loan lenders, so you will need to check each one of them to see if you qualify.

Bottom Line

Private student loans are an important option for many borrowers to cover the increasing costs of college. While not the best option for everyone, private loans can bridge the gap between a student's financial aid package and the cost of school bills.

Before applying, make sure you understand the different types of student loans available, the pros and cons of each, and which will best suit your financial needs and educational situation.