Private vs. Federal College Loans: An Overview

A college education is a top priority for many people, but the ever-increasing cost is putting it beyond many families' financial reach. If you don't have the savings to cover your or your child's college education, you may need to check out your loan options.

Key Takeaways

  • You can obtain a student loan through the federal government or from private lenders.
  • Federal loans generally have more favorable terms, including flexible repayment options. The interest is usually lower and has been indefinitely suspended during the economic crisis of 2020.
  • Students with "exceptional financial need" may qualify for subsidized federal loans while unsubsidized loans are available regardless of financial need.

Private Loans

Private college loans can come from many sources, including banks, credit unions, and other financial institutions.

You can apply for a private loan at any time and use the money for whichever expenses you wish, including tuition, room and board, books, computers, transportation, and living expenses.

Unlike some federal loans, private loans are not based on financial need. In fact, you may have to pass a credit check to prove your creditworthiness. If you have little or no credit history, or a poor one, you might need a cosigner on the loan.

Private loans may also have higher borrower borrowing limits than federal loans.

Federal Loans

Federal student loans are administered by the U.S. Department of Education. They tend to have lower interest rates and more flexible repayment plans than private loans. Interest on these loans has been suspended during the 2020 economic crisis through at least Sept. 30, 2021.

To qualify for a federal loan, you will need to complete and submit the government's Free Application for Federal Student Aid (FAFSA). The FAFSA asks a series of questions about the student's and parents' income and investments, as well as other relevant matters, such as whether the family has other children in college. Using that information, the FAFSA determines your Expected Family Contribution (EFC). That figure is used to calculate how much assistance you're eligible to receive.

The confusingly-named Expected Family Contribution (EFC) has been renamed the Student Aid Index (SAI) to clarify its meaning. It does not indicate how much the student must pay the college. It is used to calculate how much student aid the applicant is eligible to receive. The relabeling starts in Oct. 2022.

The financial aid offices at colleges and universities decide how much aid to offer by subtracting your EFC from their cost of attendance (COA). Cost of attendance includes tuition, required fees, room and board, textbooks, and other expenses.

To help make up the gap between what a particular college costs and what that family can afford to pay, the financial aid office puts together an aid package. That package might include some combination of federal Pell Grants, federal loans, and paid work-study jobs. Schools can also draw on their own resources to offer, for example, merit scholarships. The fundamental difference between grants and loans is that grants never have to be paid back (except in rare instances), while loans eventually do.

Types of Federal Loans

The William D. Ford Federal Direct Loan program is the largest and best known of all federal student loan programs. These loans are sometimes referred to as Stafford Loans, the name of an earlier program. There are four basic types of federal direct loans:

  • Direct subsidized loan
  • Direct unsubsidized loan
  • Direct PLUS loan
  • Direct consolidation loan

Note that a provision in the American Rescue Plan makes all student loan forgiveness tax-free from January 1, 2021, to December 31, 2025.

Direct Subsidized Loans

These are intended for students with "exceptional financial need." The government subsidizes the interest on the loan while the student is enrolled at least half-time. You are not charged interest on subsidized loans until you graduate, and you then have a six-month grace period after leaving school before you need to begin making loan payments. If your loan is deferred, you will not be charged interest during that period of time.

Direct Unsubsidized Loans

Unsubsidized loans are available to students regardless of financial need. Unlike subsidized loans, their interest begins accruing as soon as you receive the funds and continues until the loan is repaid in full.

Independent students who apply for a direct loan (as opposed to dependent students applying with their parents) can qualify for a higher amount of unsubsidized funds.

Direct loans have several attractive benefits, including:

  • No need to pass a credit check.
  • A low, fixed rate of interest. (Private loans often have variable rates.)
  • Several flexible repayment plans.
  • No penalty for prepaying the loan.

However, they also have some downsides, such as:

  • Low loan limits.
  • The need to file a new FAFSA form every year to maintain eligibility.
  • Stricter limits on how you can use the money than with private loans.

Direct PLUS Loans

PLUS loans are designed for the parents of college students and are not based on financial need. They have a number of appealing features, including the possibility of borrowing the full cost of college (minus any other financial aid or scholarships). They also carry a relatively low, fixed rate of interest (but higher than the rates on other direct loan types), and offer flexible repayment plans, such as the ability to defer payment until the student graduates.

PLUS loans do require that the parent applicant pass a credit check (or obtain a cosigner or endorser) and reapply for funds each academic year. The parent is also legally responsible for repaying the loan.

In addition to the parents of undergraduate students, PLUS loans are available to graduate and professional students.

Direct Consolidation Loans

When it comes time to repay student loans, the government offers direct consolidation loans, which you can use to combine two or more federal education loans into a single loan with a fixed interest rate based on the average rate of the loans you are consolidating.

You can't consolidate private loans using the federal program, but private lenders can consolidate your loans, both private and federal, by paying off your old loans and issuing you a new one. This is often referred to as refinancing.

Refinancing with a private lender can get you a lower interest rate in some cases, but you'll lose the flexible repayment options and consumer protections that come with federal loans. If you have both federal and private loans, it makes sense to consolidate the federal ones through the government program and refinance the others with a private lender.

Special Considerations

President Joe Biden and his administration have voiced their support for forgiving $10,000 in student loan debt per borrower. It's worth noting that this would only apply to federal loans. Furthermore, the Biden administration has also proposed a new, more generous income-driven payment plan. This, too, would only apply to federal loans.