Private student loans are non-federal education loans, offered by banks, credit unions, state loan agencies and other financial institutions. Private student loans can be used to pay for college costs after you’ve reached the loan limits on federal student loans and have exhausted all other sources of college funding.
State loans are considered to be private student loans because they usually have characteristics that are more similar to the student loans offered by commercial lenders than to the loans offered by the federal government.
The terms and conditions of a private student loan are set by the lender, not the federal government.
Eligibility for Private Student Loans
Lenders of private student loans are focused on profit, and not necessarily on improving college access and outcomes like the federal government. The profitability of and eligibility for a private student loan depends on factors that predict that the loan will be repaid on time and as required by the promissory note.
Credit Underwriting: Most private student loans are credit underwritten, with eligibility based on the credit scores of the borrower and cosigner (if any), as well as a review of the credit history, income, debt-to-income ratios, and duration of employment with the current employer. A better credit score increases the likelihood of loan approval.
Cosigner Required: More than 90% of private student loans to undergraduate students and nearly two thirds of private student loans to graduate students required a creditworthy cosigner. In effect, these loans are being made mostly on the strength of the cosigner’s credit history, not the student borrower’s. Even if a student can qualify for a private student loan without a cosigner, applying with a cosigner may yield a lower interest rate.
There are many things a person should consider before becoming a cosigner. The cosigner is equally responsible for repaying the loan. If the borrower fails to make payments, the cosigner is expected to repay. The cosigner’s credit is negatively impacted by late and missed payments.
Secondary Criteria: Some private student loans also consider other eligibility criteria, such as the student’s year in school, grade point average (GPA), academic major and degree level, as well as the college’s reputation and default rate. Some of these criteria are predictive of graduation and some are predictive of income after graduation. For example, a college senior is less likely to drop out than a college freshman.
School Certification: Almost all private student loans are school-certified, with more than 99.9% of new private student loans requiring school certification. When a private student loan is school certified, the college financial aid office confirms the student’s enrollment status and that the student is eligible for the loan. The financial aid office also confirms that the private student loan amount does not, in combination with other financial aid, exceed the college’s cost of attendance. If the private student loan amount is too high, the financial aid office will certify the loan for a lower amount.
FAFSA Not Required: Most private student loans do not require the student to have filed the Free Application for Federal Student Aid (FAFSA).
Key Terms of Private Student Loans
Borrower: Private student loans are borrowed by the student, often with a creditworthy cosigner. Private parent loans may be borrowed by a parent or stepparent on their own.
Interest Rates: Privatestudent loans may offer a choice of variable or fixed interest rates. Variable interest rates usually reset monthly or quarterly. Specific interest rates are determined by comparing the credit scores with four, five or six credit score tiers, which are non-overlapping ranges of credit scores. Each tier is mapped to a different interest rate formula. Most private student loans are pegged to the one-month or three-month LIBOR index rate, with some pegged to the Prime Lending Rate or U.S. Treasuries.
Most lenders do not have up-front pricing, so shop around and apply to several loans to find the private student loan with the lowest interest rate. The interest rates on private student loans tend to be higher than the interest rates on federal student loans and home equity loans, but lower than the interest rates on personal loans and credit cards. However, borrowers with excellent credit may qualify for a fixed rate on a private student loan that is competitive with the interest rates on Federal PLUS loans.
Interest Capitalization: Accrued but unpaid interest is usually capitalized (added to the loan balance) at loan status changes, such as at the end of a forbearance period or when the borrower switches to a different repayment plan. The interest on private student loans may also be capitalized at a frequency set by the lender, such as monthly, quarterly or annually.
Loan Fees: Most private student loans do not charge origination or guarantee fees. Instead, the lender rolls the cost of the fees into the interest rates. Many lenders charge late fees if the borrower is late with a payment, but some do not.
Loan Limits: Annual and aggregate limits for private student loans typically depend on the field of study and degree level. Annual limits are also usually capped at the cost of attendance minus other aid. Loan limits on private student loans tend to be higher than loan limits on federal student loans.
In-School Payments: In addition to offering full deferment during the in-school and grace periods, some private student loans offer borrowers the option of immediate repayment, interest-only payments and fixed payments (typically $25 per loan per month). Some private student loans provide discounts, such as interest rate reductions, as an incentive.
AutoPay: Most private student loans offer discounts, such as a 0.25% or 0.50% interest rate reduction, to borrowers who agree to have their loan payments automatically transferred from their bank account to the lender. Electronic billing may also be required.
Repayment Plans: Your lender may offer a grace period, which is a time after graduation or after you are enrolled less than half-time, before payments are due. This grace period varies by lender, but is typically six months. Most private student loans use level amortization, with a repayment term of 5, 7, 10, 15, 20 or 25 years. Some private student loans also offer a variation on graduated repayment, where a number of years of interest-only payments are followed by level amortization for the remainder of the repayment term. Private student loans generally do not offer income-driven repayment plans. Some lenders may not allow borrowers to change the repayment plan later, especially for private student loans with a fixed interest rate, as opposed to a variable rate.
Prepayment Penalties: Private student loans do not charge prepayment penalties, so borrowers may make extra payments on their student loans or pay off the remaining balance early. It is best to include a letter with the prepayment to specify that it is an extra payment and not an early payment of the next installment. The letter should also specify the loan ID number of the loan to which the extra payment should be applied.
Forbearance: Most private student loans offer forbearances, usually in increments of 2-3 months and for no more than a year in total duration. Some private student loans also offer partial forbearances, which provide interest-only payments instead of a full suspension of the repayment obligation.
Loan Cancellation: Some private student loans offer death and/or disability discharges. Even if the lender does not offer a formal death or disability discharge program, borrowers and cosigners can ask for a compassionate review of their situation (e.g., the borrower was killed or injured in the line of duty while serving as a member of the U.S. Armed Forces or as a first responder). Private student loans do not otherwise offer loan forgiveness programs for working in a particular occupation.
Tax Deductions: Most private student loans are eligible for the student loan interest deduction.
Legal Restrictions on Private Student Loans
Defense of Infancy: Private student loans generally require the borrower to have reached the age of majority for the student’s state of legal residence (e.g., age 18, 19 or 21).
Statute of Limitations: If the borrower has not made a payment on a private student loan in a number of years, the private student loan is considered to be “time-barred” and the lender cannot sue the borrower to collect on the debt. (More accurately, the lender can sue, but the borrower can raise the time-barred nature of the debt as an affirmative defense.) The statute of limitations is between 3 and 15 years, depending on the state, with 6 years most common.
Exception to Bankruptcy Discharge: TheBankruptcy Abuse Prevention and Consumer Protection Act of 2005 added an exception to bankruptcy discharge for qualified education loans, as defined in 26 USC 221. To be discharged in bankruptcy, the borrower of a qualified education loan must demonstrate in an adversarial proceeding that repaying the loan will impose an undue hardship on the borrower and the borrower’s dependents.
The majority of private student loans are considered to be qualified education loans. Qualified education loans must have been incurred solely to pay for qualified higher education expenses, as defined in the college’s cost of attendance and reduced by certain education tax benefits, such as tax-free scholarships, fellowships and grants, employer-paid educational assistance, education savings bonds, tax-free distributions from 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts, and Veterans’ educational assistance. Mixed-use loans and loans that exceed the cost of attendance are not considered to be qualified education loans. Bar study loans and residency & relocation loans are not qualified education loans because they are borrowed after the student has graduated.
Private Student Loan Disclosures
Private student loans are subject to the disclosure requirements specified by the Truth in Lending Act (TILA), as amended by the Higher Education Opportunity Act of 2008, and Regulation Z. Federal student loans are not subject to these disclosure requirements.
Lenders must make three disclosures to borrowers of private student loans:
- Upon loan application
- Upon loan approval
- Upon borrower acceptance of the loan
The latter is also known as the Final Disclosure.
The information that must be disclosed includes the loan’s interest rates, loan fees, late fees, default fees and collection charges, repayment terms, eligibility requirements, alternatives to private student loans, and notice of the three-day cancellation period.