How to Choose a Private Student Loan
Many lenders offer private student loans, from banks and credit unions to other financial institutions. So how do you choose a private student loan from the many options? For most borrowers, the primary considerations for choosing a private student loan include cost and repayment flexibility.
Students should remember to borrow federal first, as federal student loans are cheaper, more available and have better repayment terms than private student loans. Private student loans and Federal Parent PLUS loans are mainly used as a source of supplemental financing for borrowers enrolled at higher-cost colleges.
However, exhausting the Federal Stafford loan limits may be a sign of over-borrowing. If you borrow too much (total debt at graduation that is greater than your annual income), you will struggle to repay your student loans and will need alternate repayment plans, such as extended and income-driven repayment.
Determining the Cost of a Private Student Loan
The cost of a private student loan depends on the interest rate, fees, loan discounts and the length of the repayment term. One percentage point increase of the interest rate increases the monthly payment by 2.5% on a 5-year term, slightly less than 5% on a 10-year term and 8-10% on a 20-year term. It increases the cost of the loan by a few hundred to a few thousand dollars per $10,000 borrowed.
Loan fees are the equivalent of up-front interest. Most private student loans do not charge any loan fees, in contrast with the federal education loans. If a loan does charge fees, 4% in fees is roughly the same as a one percentage point higher interest rate, assuming a 10-year repayment term.
Loan discounts reduce the cost of the loan, to the extent that they reduce the interest rate or principal balance of the loan. Most loan discounts have a small impact on loan costs, especially if they occur later in the life of the loan and/or require the borrower to make a series of on-time monthly payments.
Benefits of Applying with a Cosigner
Most borrowers of private student loans will need a creditworthy cosigner. More than 90% of private student loans to undergraduate students and more than 75% of private student loans to graduate students require a creditworthy cosigner. In effect, the private student loan is made based primarily on the credit of the cosigner, not the student.
Even if a borrower can qualify for a private student loan without a cosigner, they should still apply with a cosigner. The interest rate on a private student loan is based on the better of the borrower and cosigner’s credit scores.
But beware, a cosigner is a co-borrower, equally obligated to repay the debt. If the borrower is late with a payment, it will affect the credit scores of both the borrower and cosigner. A cosigned loan will also affect the ability of the cosigner to get new credit, such as refinancing the mortgage on a house.
Although many lenders offer a cosigner release option, very few borrowers will qualify for cosigner release. Even if a lender has a short cosigner release period, the borrower must still be able to satisfy credit criteria on their own without the cosigner.
Comparing the Cost of Private Student Loans
When comparing different private student loans, be sure to consider both the monthly payment and the total payments over the life of the loan. A longer repayment term will yield a lower monthly payment while increasing the total payments.
For similar reasons, don’t rely on the annual percentage rate (APR) for comparing loan cost. Although the APR factors in the impact of differences in interest rates and fees, a longer-term loan will have a lower APR, even though the borrower will pay more total interest over the life of the loan.
Do not compare fixed-rate loans with variable-rate loans. Prospective borrowers have a tendency to treat the initial interest rate on a variable-rate loan as though it were a fixed interest rate. But variable interest rates change over time. The interest rate on a variable-rate loan may initially be lower than the equivalent fixed interest rate, but will eventually increase.
A variable-rate loan may be less expensive if you choose a shorter repayment term or if you intend to pay off the loan before interest rates increase too much. Lenders will also be more flexible about increasing the repayment term on a variable-rate loan than on a fixed-rate loan.
Avoid private student loans with fixed interest rates and non-zero fees if you intend to pay off the debt early. Fixed interest rates are designed to yield the same total revenue to the lender as a variable interest rate over the term of the loan. So, in a rising rate environment, a fixed rate effectively charges more money earlier in the repayment term and less money later in the term, as compared with prevailing interest rates at the time. If you prepay the loan, you are paying more than you would on a variable-rate loan and on a no-fee loan.
Other Criteria for Choosing a Private Student Loan
Some lenders may offer short repayment terms, such as 5, 7 or 10 years. While a shorter repayment term will save you money, it may not provide you with the flexibility you need to repay the debt over a longer term. Lenders tend to offer lower fixed interest rates on loans with shorter repayment terms, since there is less time for the lender’s cost of funds to increase.