Differences between federal student loans and private student loans

July 12, 2018

There are several important differences between federal student loans and private student loans, besides just the source of funds. These differences include cost, eligibility criteria, repayment options and safety nets. Generally, federal student loans are cheaper, more available and have better repayment options than private student loans.

Source of funds and loan terms

The most obvious difference between federal student loans and private student loans is in the source of funds.

Federal student loans, also known as Direct Loans, are funded by the federal government through the U.S. Department of Education’s William D. Ford Federal Direct Loan Program. Terms of federal student loans are set by the Higher Education Act of 1965.
Private student loans are funded by banks and other financial institutions. Portfolios of private student loans may be funded by the capital markets through securitization. Each lender sets its own loan terms, subject to restrictions established by the Truth in Lending Act of 1968 (TILA).

Cost of student loans

Differences in interest rates and fees are the primary source of differences in loan costs.

Federal student loans have low fixed interest rates that do not depend on the borrower’s credit history. Interest rates on subsidized Federal Stafford loans are effectively zero during the in-school and grace periods, as well as periods of authorized deferment. The loan fees on the Federal Stafford loan are about 1%, while the loan fees on the Federal PLUS loan are about 4%.
Private student loans may offer fixed and/or variable interest rates. In most cases the interest rates depend on the borrower’s credit score and the credit score of the cosigner, if any, yielding better pricing for better credit customers. Fixed interest rates may require a shorter repayment term. Most private student loans offer zero fees by building the loan fees into the interest rate.

Use our Loan Comparison Calculator to compare the cost of multiple loans.

During deferments and forbearances, unpaid interest continues to accrue and will be capitalized by adding it to the loan balance. Interest capitalization on Federal Direct Loans occurs once, at the end of the forbearance or deferment period (i.e., at loan status changes). Interest capitalization on private student loans may be more frequent, for some loans as frequent as monthly. Interest capitalization causes interest to be charged on interest, increasing the cost of the loan slightly.

Overall, federal student loans are less expensive than private student loans. Private student loans may be less expensive for some borrowers if the borrower (or cosigner) has excellent credit or if the borrower pays off a variable-rate loan before interest rates rise too much. But, federal student loans also offer superior repayment benefits that are not available to borrowers of private student loans.

Eligibility for federal and private student loans

The main impact of differences in eligibility for federal student loans and private student loans is that borrowers are sometimes forced to borrow from private student loans after reaching the federal student loan limits.

Federal student loans require all borrowers to file the Free Application for Federal Student Aid (FAFSA). This determines how much of a student’s Federal Stafford loan eligibility is subsidized and how much is unsubsidized. Eligibility for the subsidized Federal Stafford loan depends on financial need. Eligibility for federal student loans does not depend on the borrower’s credit scores or credit history and cosigners are not required.
Eligibility for private student loans does not depend on the FAFSA, but it does depend on the credit scores of the borrower and cosigner. More than 90% of private student loans to undergraduate students require a creditworthy cosigner. Private student loan may also depend on debt-service-to-income ratios and minimum income thresholds.

Another key difference between federal student loans and private student loans is in the loan limits. Federal Stafford loans have relatively low annual loan limits and aggregate loan limits. Private student loans tend to have higher annual and aggregate loan limits.

Flexible repayment options

Federal student loans generally have more flexible repayment options than private student loans.

Federal student loans offer extended repayment, graduated repayment and income-driven repayment plans in addition to standard 10-year repayment, while private student loans offer more limited repayment plans. Some private student loans offer a choice of repayment terms, but generally charge a higher interest rate for longer repayment terms.

See our Income Driven Repayment Plan Calculators

Federal student loans offer a variety of loan forgiveness options for borrowers who work in specific occupations, while private student loans do not.

The interest on federal student loans and private student loans is eligible for the student loan interest deduction. The student loan interest deduction is an above-the-line exclusion from income for up to $2,500 a year in interest on federal and private student loans. The student loan interest deduction can be claimed on your federal income tax return even if you do not itemize.

Safety nets for struggling borrowers

If a borrower runs into financial difficulty, there generally are more safety nets for federal student loans than for private student loans.

Both federal student loans and private student loans offer temporary suspensions of the repayment obligation, called deferments and forbearances. But, the deferments and forbearances are longer for federal student loans, up to 3 years in total duration, compared with just one year for private student loans. Private student loans may require the borrower to make interest-only payments during a partial forbearance, to prevent the loan from getting larger.

All federal student loans offer death and disability discharges. About half of private student loans offer similar discharges. Federal student loans also offer closed school discharges and false certification discharges, which are not available on private student loans.

Federal student loans offer income-driven repayment plans, while commercial private student loans do not. An income-driven repayment plan bases the monthly payment on the borrower’s income, as opposed to the loan balance, yielding a lower monthly loan payment. The remaining debt is forgiven after 20 or 25 years in repayment (10 years for public service loan forgiveness).

Both federal student loans and private student loans are almost impossible to discharge in bankruptcy. It might be slightly easier for a borrower to get a private student loan discharged in bankruptcy, since private student loans do not offer as many safety nets as federal student loans.

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