Private Student Loan Basics

NOTICE: This discussion of private student loans is under revision to reflect reduced availability in 2009-2010 school year and new consumer protections that become effective in February of 2010. Watch this space for more information.

The actual cost of your education and your family’s ability to contribute to your education, the Expected Family Contribution (EFC), may limit the amount of government-sponsored loans you are eligible to receive. When federal and state student loans do not provide enough money to cover the cost of education, students and their families often turn to private student loans to fill the gap.

Private loans are offered by private lenders and there are no federal forms to complete. Eligibility for private student loans often depends on your credit score. The interest rates and fees on private student loans are based on your credit score and the credit score of your cosigner, if any. In the current "credit crunch" of 2008, if your credit score is less than 700 (FICO), it is difficult to be approved for a private student loan. This situation may improve in 2009. Regardless of the minimum credit score for a loan, an increase of just 30 to 50 points in your credit score is often enough to get you more favorable terms on your private student loans.

One disadvantage of private student loans is that they typically cost more than loans obtained through the federal government. Federal loans offer fixed interest rates that are lower than the loans offered by most private student lenders. Federal loans also feature more flexible repayment and forgiveness options. Since federal loans are less expensive and offer better terms than private student loans, you should exhaust your use of federal student loans before resorting to private student loans.

While federal student loans have fixed rates, private student loans typically have variable interest rates, with the interest rate pegged to an index, plus a margin. In other words, the interest rate of your loan may change based on an agreed upon formula. The most commonly used indices are the Prime Rate and the LIBOR. The LIBOR, or the London Interbank Offered Rate, represents what it costs a lender to borrow money. The Prime Rate on the other hand is the interest rate lenders offer to their most creditworthy business customers.

One of the biggest challenges student borrowers face when trying to get a private student loan is their lack of credit history. It is, therefore, better to apply for a private student loan with a cosigner even if you can qualify for the loan on your own. Applying with a cosigner can result in more favorable terms because loans with co-signers are not as risky for the private lender. Furthermore, the interest rates and fees are usually based on the higher of the two credit scores. So if the cosigner has a much better credit score than you, you may benefit by getting a better interest rate.

Private student loans may be used to pay for the EFC, the portion of college costs the federal government expects your family to contribute. Some lenders may offer private student loans in excess of the cost of attendance. Keep in mind that any amount that exceeds the difference between the cost-of-attendance and any financial aid you receive will be treated like an outside scholarship. This will reduce your ability to get need-based aid. This limitation applies to education loans, in which enrollment in college is a condition of the loan. Where the loan proceeds are disbursed (e.g., direct to the borrower vs. to the school) or how the loans are marketed is irrelevant. Mixed-use loans, such a home equity loans and credit cards, are not considered education loans and are therefore not limited by cost-of-attendance.

Some lenders offer non-school-certified private student loans to bypass this limitation by not informing the college about the loan. If the college becomes aware of the loan, federal regulations require the college to reduce need-based aid. Recent federal legislation will require all borrowers to send the lender a form provided by the school that sets forth the student’s financial need for loan funds. Lenders may be less likely to encourage "overborrowing" if they know exactly how much money the student needs to borrow.