Figuring out how to pay for college can be a stressful, complicated process. I remember being overwhelmed when I started at a pricey private college, which I paid for with a hodgepodge of scholarships, grants, federal and private loans, work study, and my own money.
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In this article, I’ll outline the basics of federal student loans and private student loans, discuss whether private student loans make sense, look at the interest-rate climate in 2016, and explain how to get started in your search for the best student loans.
Finding and Comparing the Best Student Loans
Using an online tool like Credible.com or SimpleTuition.com can ease your search for the best private student loans by letting you directly compare loans and interest rates from different lenders. Just a few minutes and a minimum amount of personal information will generate a number of options.
Private loans can make sense when you’ve borrowed all you can in federal student loans, qualify only for the highest federal interest rates, or need funds quickly. I relied on a small private student loan to fill an unexpected gap in funding my senior year — I was able to get the money almost immediately, but because the interest rate was higher than my other loans, I prioritized paying it back faster.
If you’re not sure whether private or federal loans are the best choice, keep reading.
How to Pay for College: Prevailing Wisdom
When it comes to paying for college, most financial experts dispense similar advice that follows this roadmap:
- Use free money first. Simply put, this means grants, scholarships, or any other option that doesn’t require repayment. I was fortunate to qualify for a number of grants and scholarships that made going to a private college even cheaper than a public institution. Because of them, I owe a lot less in loans than many of my classmates.
- Use federal loans next. Traditionally, this has been no-brainer advice because Uncle Sam has offered low-interest, fixed-rate loans that eclipsed the offerings of most private lenders. What’s better is if you qualify for subsidized loans like I did (with these, the government will pay your interest while you’re in school).
- Use private loans last. Accordingly, many experts caution against private loans because most low interest rates are variable (and likely to rise over time), while fixed rates are usually higher than the rates on federal loans. As I mentioned above, I had to take out a small private loan at one point — it was convenient, but the interest rate was higher than my other loans.
So, is prevailing wisdom still solid for 2016? Let’s take a look at the interest-rate climate as a starting point in our search for an answer.
A Primer on Student Loan Interest Rates
The interest rate on your loan is the percentage of the principal, or overall loan amount, that you’ll have to pay back to the lender on top of the principal.
This is calculated many times over the life of your loan on the total amount you owe, including the interest and fees. That’s why you won’t owe only $10,600 after taking out a $10,000 loan with a 6% interest rate. According to this federal repayment estimator, you’ll actually be on the hook for $13,332 on a standard 10-year payment plan. That’s why even a slightly lower interest rate can save you a lot of money in the long run.
Federal student loan interest rates
Interest rates on undergraduate Direct Loans recently fell from 4.66% for the 2014-2015 school year to 4.29% for the 2015-2016 school year. Rates are higher for graduate Direct Loans (5.84%) and Direct PLUS Loans (6.84%). These rates are locked in for loans first disbursed between July 1, 2015 and July 1, 2016. Remember, even though rates can reset each year, the rate you receive when your loan is first disbursed remains your rate for the life of the loan.
Federal student loan rates are tied to a 10-year Treasury note — basically, this is a loan investors can make to Uncle Sam. When the rate of return (or yield) on this note rises, you will see it reflected in rising federal student loan rates. When it falls, student loan interest rates fall, too.
The number that matters is the yield during the May Treasury auction. Officials add 2.05% to that number to determine the new rate for undergraduate Direct Loans, 3.6% to determine the rate for graduate Direct Loans, and 4.6% to determine the rate for PLUS Loans.
These percentages are interest-rate cushions set by Congress. Whether federal student loan rates rise or fall depend on how the yield on the 10-year Treasury note compares to the yield from the same time last year.
Private student loan interest rates
Private lenders offer both variable and fixed-rate loans, and the rate you’ll obtain is a direct result of your credit history (and your cosigner’s, if you have one).
I used Credible to get personalized offers for a hypothetical student graduating from my own alma mater, American University, in 2016. The personalized interest rates my “student” received ranged from 1.93% with College Ave to 7.49% with Citizens Bank.
A 1.93% interest rate on a private student loan certainly seems better than 4.29% on a federal Direct Loan, but there’s much more to these numbers than meets the eye. That’s a discussion I’ll return to after a primer on the types of federal loans and private loans, and their respective pros and cons.
Federal Student Loans
There are two federal student loan programs: The Perkins Loan Program and the Direct Loan Program. The former program is much smaller than the latter. You must file a Free Application for Federal Student Aid (FAFSA) to be considered for federal student loans.
Below, I’ll list each type of loan in descending order of desirability, with the most favorable loans first.
A federal Perkins Loan is almost always going to be your best student loan option if you are eligible. I was awarded a Perkins Loan each year as part of my undergraduate aid package, and it was always a welcome sight in my award letter.
Your school, which functions as the lender in this case, awards Perkins Loans as part of a financial-aid package to students who demonstrate significant financial need — essentially, this means it will cost much more for you to attend school than your family can afford to pay; the bigger the gap, the more significant the need. This loan is subsidized, meaning interest is paid for you while you’re in school. (If you need a detailed primer on other loan terminology, see our guide to student loan vocabulary.)
- Interest rate is fixed at 5% and does not reset yearly like other federal loans
- Your interest is paid while you’re in school
- No loan origination fees (charged for creating the loan) that reduce the amount you receive
- Undergraduates can borrow only $5,500 a year and up to $27,500 total; graduate students can borrow only $8,000 a year or $60,000 total (or less if they borrowed Perkins Loans as undergraduates)
- You must have extreme financial need to qualify
- Your school must qualify to offer this type of loan
Direct Subsidized Loans
Direct Subsidized Loans are also reserved for students who demonstrate financial need via their FAFSA, but the bar is lower here. While your school is your lender for a Perkins Loan, Uncle Sam is your lender for Direct Loans. Only undergraduates are eligible for Direct Subsidized Loans.
- Interest rate is fixed (current rate is 4.29%)
- Your interest is paid while you’re in school
- Undergraduates can borrow only $3,500 to $5,500 a year and up to $23,000 total; graduate students aren’t eligible
- You must have significant financial need to qualify
- Small origination fee (1.068% of each disbursement)
Direct Unsubsidized Loans
Good news: You can qualify for Direct Unsubsidized Loans without demonstrating financial need, and all undergraduate and graduate students are eligible.
Bad news: You’re on the hook for the interest that accrues while you’re in school, though you can choose not to pay it until after you’re done (however, this means you’ll end up paying more overall).
- Interest rate is fixed (current rate is 4.29% for undergraduates; 5.84% for graduate students)
- Available to all students regardless of financial need
- Undergraduates can borrow only $5,500 to $7,500 a year and up to $31,000 total; graduate students can borrow only $9,500 to $12,500 a year and up to $138,500 total (or less if they borrowed any federal loans as undergraduates)
- Your interest will not be paid while you’re in school
- Small origination fee (1.068% of each disbursement)
Direct PLUS Loans
PLUS Loans allow graduate students and the parents of undergraduate students to pay for educational costs in excess of what other financial aid, including the federal loans listed above, might cover. Unlike other federal loans, a credit check is performed; those with spotty credit history may not qualify. Those who don’t qualify for the PLUS program may be able to borrow more direct unsubsidized loans.
- Loans can often be used to pay a greater range of educational expenses other than tuition, housing, and books
- You can borrow as much as you need to cover the cost of attendance minus other financial aid
- Interest rate is fixed (current rate is 6.84%)
- For undergraduates, parents must sign for this loan on a student’s behalf
- Hefty loan origination fees (4.272% of each disbursement)
- Credit history will factor into whether you receive a loan
- Highest interest rate of all federal student loans
Other federal student loan benefits
Aside from the more appealing interest rates, there are several other reasons federal student loans are considered the best student loans, and why you should consider them before private student loans:
- Repayment plans can be more flexible than those offered by private lenders, offering students the ability to make payments more proportional to their income (this is especially useful when you start out with a low salary that rises over time, and is a feature I’ve taken advantage of while paying back my federal student loans).
- Deferment and forbearance allow you to stop making payments for a period of time (the former is more attractive because interest does not build up during deferment). These benefits can be a lifesaver during periods of financial hardship, and they often aren’t offered by private lenders.
- Uncle Sam will also forgive your loan if you die or become permanently disabled — some private lenders offer this benefit, but many do not.
- There are loan forgiveness options for students who go into certain public service careers, join the military, move to certain locations, or volunteer with certain organizations. These programs aren’t available through private lenders.
Private Student Loans
Private student loans are on offer at scores of banks and credit unions. Sallie Mae, which originally provided federal student loans, is probably among the most well-known private lenders. Interest rates vary from lender to lender, and they can be either variable (more common, especially with lower rates) or fixed. This makes it crucial to shop around using a site like Credible or SimpleTuition.com if you’re in the market for a private student loan.
- Applying is quick and easy compared to filling out the FAFSA
- Loans can be used to pay for a greater range of educational expenses other than tuition, housing, and books
- You can usually borrow as much as you need to cover the cost of attendance minus other financial aid (this is subject to lender approval)
- Funds are typically disbursed immediately upon approval
- Loans often have no origination fees
- Cosigners can be anyone with good credit (not just parents)
- Cosigners can be released from the loan after a period of on-time payments
- Credit history will factor into whether you receive a loan and what kind of interest rate you’ll receive
- Interest rates are often variable and may be higher than those offered by federal loan programs
- You may have to start repaying the loan while you’re still in school
- Flexible repayment plans, loan forgiveness, and other benefits aren’t guaranteed
Federal Loans vs. the Best Private Student Loans: A Quick Case Study
As I mentioned at the beginning of this article, conventional wisdom holds that private student loans are almost never as good a deal as federal student loans. In most cases, this is true. However, if you’ve exhausted your federal loan options or have very limited options, private loans can be the way to go, especially for parents who don’t want to take out a PLUS loan on behalf of their child.
Let’s return to my fictional college student, who was comparing interest rates on a $20,000 loan. Again, rates ranged from 2.25% (this rate would require excellent credit) to 12.61% (this rate would be for those with less-than-stellar credit).
Assuming my fictional student can land anything close to that sweet 2.25% loan, why isn’t that a better deal than a federal Direct Loan with a 4.29% interest rate? First, if you qualify for a subsidized Direct Loan, you aren’t paying interest while you’re in school — Uncle Sam is picking up the tab for you.
But even if you qualify only for an unsubsidized Direct Loan and pay interest during school, your rate is fixed at 4.29%. With the private loan, it’s 2.25% today, but who knows what it will be next year, or in five years, or in 10 years? Aside from the possibility of a major interest-rate hike, the variable interest rate can make it hard for you to budget for loan payments.
What if your only option is a federal PLUS loan with a 6.84% interest rate? The higher interest rate certainly muddies the water if you can get a significantly lower rate with a private lender.
Still, the fact remains that you know what you’ll be paying for the life of the PLUS loan, while the private loan remains a question mark. Experts caution that a rock-bottom 2.25% interest rate has nowhere to go but up. When that happens, you could actually be looking at the equivalent of a 6% to 7% fixed-rate loan — much closer to the PLUS loan. The fact that Uncle Sam offers more flexible payment plans and loan forgiveness options could still tip the scales in favor of federal loans, assuming parents are willing to sign on the dotted line.
There’s one more wrinkle, though. Remember that private lenders offer fixed rates, too. Sallie Mae also advertised a 5.74% fixed-rate loan for my student.
Assuming I’m OK with the fine print (such as potentially stricter repayment options), this could be my best deal if I’ve borrowed all I can at a lower federal interest rate. The 5.74% interest rate means a savings of nearly $1,800 in interest over the life of the loan over the 6.84% PLUS loan.
One interesting private option that I came across online is SoFi. While SoFi doesn’t offer undergraduate student loans, it does offer refinancing loans for students down the road. It also offers “parent loans” at fixed rates as low as 4.50% and MBA loans for graduate business students at fixed rates as low as 6.05% at certain elite schools. SoFi does not charge origination fees or prepayment penalties on its parent loans, but you will be capped at a 10-year repayment period.
Four Tips for Getting the Best Student Loan Rates from Private Lenders
Tip #1: Shop around
It’s obvious, but it’s crucial: You need to compare lenders to find the best student loan rates. Maybe your family has been banking at the same place for years. It could be tempting to take out a loan with your tried-and-true lender and call it a day — but that’s not a wise move unless you know the rate is competitive.
Just as you would shop for the best price on a car, you should shop for the lowest interest rate on a student loan. Sites like Credible or SimpleTuition.com can help you compare rates from different private lenders.
Tip #2: Look beyond the interest rate
Be sure you’re comparing apples to apples by looking at loans for the same amount for the same repayment term, and note whether the rate is variable or fixed. Other things to note:
- What are the fees? According to FinAid.org, if you’re paying 3% to 4% in origination fees, that can roughly approximate to a 1% interest-rate hike.
- What is the grace period before you have to start making payments?
- How flexible are repayment plans, and can you defer payments?
- Are there any borrower rewards — for example, interest-rate reductions for on-time payments, automatic withdrawal, or good grades?
Tip #3: Polish your credit (or secure a credit-worthy cosigner)
Just because a private lender will make you a loan doesn’t mean you should take it. Many students have short or poor credit histories, which costs them dearly in the form of higher interest rates. So if your credit history is brief and less than stellar, you’ll need a cosigner with great credit to help you nab a good interest rate. Here’s a primer on how to build credit safely.
Tip #4: Apply for several loans
Simply seeing what rates are out there probably isn’t going to cut it — you’ll need to actually apply for the loan to make sure you can secure the interest rate you’re eyeballing. You may be surprised at the rate you actually receive, either pleasantly or unpleasantly.
Start Now to Find the Best Student Loans
Taking out student loans can be overwhelming, especially when it’s the only way you can pay for your education. While federal student loans remain the best option for most students, the best private student loans can be a compelling option for those who have maxed out their federal loans or who can land a very competitive interest rate because of excellent credit.
The first step to obtaining federal student loans is filing your FAFSA — the earlier, the better. If you’re considering a private lender, you’ll want to start by shopping around for the best student loan rates using a site like Credible.com or SimpleTuition.com.
Once it’s time to think about repaying your student loans, The Simple Dollar has a number of articles with great advice. Learn how to consolidate your loans, make extra money to pay your loans, determine whether it’s better to save or pay your loans aggressively, and figure out how to reduce your loan payments if you’re in trouble.