Education Planning
For College Costs, Watch Out for Loan Differences
With the cost of higher education rising exponentially, it has become increasingly more difficult for many students to fund their education. Now more than ever, students and parents are looking to lenders in order to borrow the money needed to pay for education expenses.
There are two categories of loans that are specifically for education: Federal and private. Federal student loans are the type of loans with which most people are familiar, and the ones that are most often associated with the term "student loans." The best known Federal student loan is the Stafford loan. Private student loans are offered through a variety of sources, some of which also offer Federal student loans.
There are some very important differences between the two categories of education loans. Federal student loans are guaranteed by the U.S. government, and that guarantee generally leads to lower rates of interest. Private loans are based on the personal credit history and Fair Isaac Corporation (FICO) score of the borrower, frequently a young student with very little, if any, credit history. There are often no limits on the fees or interest rates that private lenders may charge borrowers. These features often result in higher interest rates for private loans.
With the rapid rise in college costs over the last few years, Federal student loan dollars, which are capped at a relatively low number both annually and overall, are increasingly becoming insufficient as the only source of money for cash-strapped students. For this reason, there has been a recent jump in the percentage of undergraduates who take out private student loans.
Additionally, confusion exists among borrowers. Many young students, and in some cases their parents, do not understand the important differences between the two types of loans. Perhaps preying on this naiveté, many private loan applications are designed to be faster and easier to fill out than the Federal student loan applications.
The problems with private loans often arise shortly after graduation. Federal student loans offer more favorable, flexible repayment terms and more opportunities for loans to be forgiven. Many private loans offer a "teaser", low interest rate while the student is in school (and apt to not be paying back any portion of the loan), but that interest rate jumps substantially following graduation, when a repayment plan may begin.
Another issue that often becomes apparent after graduation is that consolidation of private loans is separate from and less attractive than consolidation of Federal loans. Private-loan consolidation results in an interest rate that is still based on the borrower's credit history and is thus higher than for consolidated Federal loans.
A work around that is often used, but not recommended, is for parents to co-sign private loans in order to get a more favorable interest rate for their son or daughter. There is a huge downside to this action, however. Co-signing on the loan puts parents on the hook for paying back the loan if their child cannot, often at a time when the parents are hoping to retire. And with an adjustable interest rate, payments on these private loans can become quite high.
Moreover, borrowers repaying Federal loans are entitled to defer payments if unemployed or suffering an economic hardship. Private lenders, however, aren't required to offer any hardship deferments for repayment. Federal loans offer debt forgiveness in certain scenarios. Private loans do not provide for debt forgiveness, and in fact are nearly impossible to escape. A provision in the new, stricter bankruptcy law that took effect in 2005 makes it nearly impossible for borrowers to erase student loan balances in a Chapter 7 bankruptcy. In order to erase the loan, a borrower would have to prove in court that they will never earn enough money to repay the loan.
Private student loans should be used to cover college expenses only as a last resort, unless there is an expectation that payoff will be quick and relatively easy upon graduation. Often, there are alternatives that are more financially sound. If you or someone you know is looking for ways to fund a higher education, Pleasanton Financial Advisors can help with recommendations.