Many families worry about how to choose a college that fits their budget. Student loans are one of the most common ways to make up the difference between what a student can afford and what college costs. When the term “student loan” is mentioned, many people automatically think of federal loans. While these government-issued loans are the most common type of financing used to cover college expenses, they are not the only option available.
Private student loans provide another way to help you cover tuition, fees and other educational costs.
What are private student loans?
Private student loans are offered by financial institutions, such as banks and credit unions, to help students pay for college expenses. As with most other types of loans, the total amount that can be borrowed, interest rates and terms will vary depending on the lender and the borrower's creditworthiness.
Although private student loans offer an alternative way to pay for college and a method to address funding gaps that federal loans don’t cover, they also come with increased risks and less favorable terms than loans issued by the federal government. For that reason, students should always max out their federal student loans before turning to private loans. Even then, it's crucial to understand the unique characteristics of private student loans before you borrow.
Why are private student loans the riskier option?
There are several unique features of private student loans that make them a riskier, and sometimes more expensive, borrowing option than federal loans.
1. They can damage your credit record if not paid on time
One of the most significant risks of private student loans is the potential for long-term damage to your credit record if you fail to pay them on time. Forbearance options are limited with private students, making it difficult to pause or skip a monthly payment if you have a short-term cash crunch.
Plus, private loans can go into default as soon as you miss three monthly payments. (With federal loans, you don’t default on your debt until you miss nine monthly payments.) Defaulting on your loans will sink your credit score and cause long-term damage to your credit record.
2. There are fewer loan deferment options should you face financial hardship
Another risk of private student loans is the lack of loan deferment options. With federal student loans, holders can take a break from loan repayment for up to three years if they experience financial hardship. On the other hand, private lenders’ hardship protections vary and are often granted on a case-by-case basis. In general, they are much more limited than what’s available with federal loans, leaving borrowers with fewer options if a financial emergency arises.
3. There are no annual borrowing limits
Although your school’s financial aid office will determine the amount of federal student loan funds you are eligible to receive, there is also an overall annual limit that applies to all federal student borrowers. As of 2023, undergraduate students are limited to borrowing up to the following:
- $5,500 for first-year dependent students and $9,500 for independent students
- $6,500 for second-year dependent students and $10,500 for independent students
- $7,500 for dependent students in their third year and beyond and $12,500 for independent students
There are also aggregate loan limits in place for undergraduate students using federal loans. Dependent undergraduate students have a total loan limit of $31,000, and independent undergraduate students have a total loan limit of $57,500. (Dependent students are students who are under 24 and have parental support.)
Private student loans, on the other hand, determine loan amounts based on a student’s credit history and income. This means there is no set overall limit to the amount of private student loans they can borrow; you may be allowed to borrow up to the full cost of attendance at your college. While this might seem like an advantage, it's also a significant risk if the student borrows more than they can afford to pay back.
4. Private loans are unsubsidized loans
Federal student loans are offered in both subsidized and unsubsidized varieties. Subsidized loans, which are only given to students with financial need, do not accrue interest while the student is enrolled. That can reduce the amount of money a student has to pay back in the long run.
Unsubsidized loans, on the other hand, accrue interest from the moment they are taken out, increasing the total loan amount that must be repaid. Private loans are all unsubsidized, which can significantly increase the overall loan repayment amount.
5. Private loans usually require a cosigner
A cosigner is someone who agrees to assume financial responsibility for a loan if the borrower fails to repay it. While federal student loans never require a cosigner, private student loans for undergraduate programs almost always do. That’s because most students have a very limited credit history and lack a steady income, so they don’t meet lenders’ borrowing requirements on their own.
In these cases, the borrower must find someone willing to cosign the loan, usually a parent or other family member. Needing a cosigner isn’t a risk on its own, but it creates an added risk for the cosigner. They become just as responsible for the loan as you are. If you fall behind on your payments, the cosigner has to pay, and if they don’t, their credit will suffer.
6. There are no student loan forgiveness options
Federal student loans come with many loan forgiveness options, such as Public Service Loan Forgiveness and Teacher Loan Forgiveness. These forgiveness programs can help reduce or eliminate the loan balance for eligible borrowers. Private student loans, however, have no loan forgiveness options and must be repaid in full.
There are a few exceptions: If a borrower dies or becomes disabled, most lenders discharge the debt, though in some cases a cosigner will still be held responsible. You can also try to discharge a private student loan through the bankruptcy process, but stringent requirements make that a complicated, difficult path for most borrowers.
7. Private lenders don't offer income-driven repayment plans
Income-driven repayment plans are available for federal student loans and can help borrowers manage their loans by basing monthly payments on the borrower’s income. They can be a lifeline if you lose your job or don’t earn enough to cover all your bills. These repayment plans typically reduce monthly payments and extend the loan term. They even provide forgiveness of the remaining loan balance after a certain number of years.
Private lenders typically offer just a few standard repayment terms and crucially, they don't offer these income-driven repayment plans. This means that borrowers are responsible for making payments on their loans regardless of financial hardship or changes in income.
Summary of Money's Risks of Private Student Loans
There are many ways to finance college, from looking into the best scholarship websites for college students and researching grants to applying for student loans. Many students end up with a mix of funding. If you're considering taking out a student loan, it's essential to understand the differences between federal and private student loans.
Federal student loans offer more flexibility, with income-based repayment plans and loan forgiveness options, while private student loans are typically more expensive due to higher interest rates. They also have less flexible repayment options and no loan forgiveness. By researching and comparing your options, you can find the ideal method for financing your college education.
Kristen Kuchar contributed to a previous version of this story.