What Are Private Student Loans and How Do They Work?

Private student loans are a viable option to cover college costs. But due to their generally higher interest rates and lack of borrower protections, it usually makes sense to exhaust federal student loan options before turning to private lenders.

While just 6% of undergraduates at public four-year colleges borrowed private loans in the 2019-20 school year, less than half of these students maximized their federal loan opportunities, according to an analysis by The Institute for College Access & Success.

Current private student loan rates

This guide explores what qualifies as a private student loan, how private student loans work, and when to consider this loan type.

What is considered a private student loan?

Private organizations issue private student loans. In contrast, the government funds federal student loans.

Private student loans lack the built-in borrower protections of federal student loans. Additionally, for borrowers without excellent credit, private student loans tend to have higher interest rates than federal student loans, which leads to a higher overall cost of borrowing.

Who offers private student loans?

Private lenders for student loans include banks, credit unions, and online lenders.

While many different financial institutions offer private student loans, the eligibility requirements vary from lender to lender. For example, each lender usually has its own minimum income requirement or credit score threshold you must meet in order to be approved.

Key differences between private and federal student loans

Private and federal student loans differ in several key areas, including:

Interest rates

Federal student loans come with fixed interest rates. Typically, these rates are lower than those available through private student loans.

In contrast, private student loans can come with either fixed or variable rates. While private student loan interest rates are generally higher than those of federal student loans, you might qualify for lower rates if you have excellent credit.

Repayment terms

Federal student loans don't require any payments until after you leave school or drop below half-time status and complete your six-month grace period. In contrast, some private lenders require borrowers to start making payments immediately after the loan funds are disbursed.

Beyond when you start making payments, federal borrowers enjoy access to a variety of repayment plans. These include income-driven repayment plans, which set your monthly payment based on your income and family size. Private lenders don't offer such generous repayment terms.

Borrower protections

Federal loans come with protections built in. For example, borrowers can become eligible for loan forgiveness after completing their repayment term on an income-driven repayment plan or by meeting eligibility requirements for other forgiveness programs, such as Public Service Loan Forgiveness.

The government can also pause repayment obligations to protect borrowers during times of economic instability, such as the payment pause during the COVID-19 pandemic. Additionally, federal loans allow you to postpone or lower your payments temporarily in some situations.

Private student loans don't come with any forgiveness opportunities built in, and deferment opportunities vary from lender to lender.

Eligibility criteria

Unless you're seeking a Direct PLUS Loan, federal student loans don't require a credit check. And you won't need a cosigner to take out federal student loans.

Generally, private lenders require a credit check. If your credit score isn't sufficient, you'll need to find a cosigner with strong credit to help you take out the loan.

Pros and cons of private student loans

Every financial product has benefits and drawbacks to consider, and private student loans are no exception.

Advantages

“Borrowers, and cosigners, could get a lower interest rate than equivalent federal loans,” says Jack Wang, a wealth adviser at Innovative Advisory Group who focuses on helping families cover college costs.

“Some private student loan lenders also offer perks such as resume writing help, a 'discount' for good grades, and similar,” he adds. “Another non-financial benefit is that sometimes parents use cosigned parent loans as a way for the student to have a stake in paying for college.”

Disadvantages

“Private student loans' biggest disadvantage is you don't get the same federal student loan benefits, such as income-driven repayment options after college,” says Reyna Gobel, author of “Graduation Debt: How To Manage Student Loans and Live Your Life.”

Gobel continues, “While a lower interest rate can be tempting versus a parent or graduate PLUS loan, there is a risk of not being able to afford payments. You also will have zero chance at Public Service Loan Forgiveness, a plan that makes it easier to pay back loans within 10 years if you work for a public service employer.”

When should you consider a private student loan?

Generally speaking, the built-in borrower protections of federal student loans make them a more attractive option. If you need to fill a funding gap between your school costs and your federal aid, then private student loans might be the right solution.

But it's important to consider your long-term goals before jumping into private loans over federal loans.

“The normal advice is to max out federal loan eligibility first, but that's not always necessary,” says Wang.

“If a student is going to enter a high-paying, stable industry and not otherwise qualify for loan forgiveness, a private student can be a viable option,” he adds. “Also, nothing prevents a student or family from using a mix. There's no requirement to use only federal or private.”

Also, remember that you have the option to refinance federal loans through a private lender after graduation if you feel that would better suit your situation, though it's typically best not to go this route.