Teachable Moment

Andrew Rombach

FOR THREE-QUARTERS of students, loans have become a standard part of the college experience. Scholarships, grants and parental funding may be preferable. But the reality is, many families will need student loans to pay college expenses.

Navigating this world can be baffling. There are many different kinds of loans and repayment programs, and choosing the right option is important. After all, you’ll be living with your choices for 10 years or more.

Federal student loans are backed by the federal government and offered through the Department of Education. There are two major types of federal loan—Direct and Perkins. The Direct Loan program is by far the largest of the federal offerings. With the Direct Loan program, the Department of Education is the lender; with the Perkins Loan program, the school itself is considered the lender.

When it comes to federal direct student loans, the driving criteria is financial need; creditworthiness isn’t a factor in the decision. There are four kinds of direct loans through the federal government: direct subsidized and unsubsidized, direct PLUS (for both parents and graduates) and consolidation loans. While each type differs slightly, in all cases the student will borrow from the federal government and will make their payments to a servicing company the government selects.

Benefits to borrowing through the government are many. Typically, borrowers get a lower interest rate with federal loans. There are also many repayment options available, including graduated and extended repayment plans. For borrowers who get into financial trouble, there are income-driven repayment programs, direct consolidation loans, forbearances and deferments—all designed to help borrowers stay out of default.

There are, however, drawbacks as well. While all loans affect your credit score, a federal loan can also affect your ability to get an income tax refund or other federal services. If you default on a federal student loan, for instance, you won’t just see your credit score drop. On top of that, you could see your tax refund put toward your loan payments or find your paycheck garnished.

Private student loans are an alternative for those who don’t want to go the federal route. This type of student loan is offered by a bank or other lender, and is based upon creditworthiness instead of financial need. They’re getting more popular. About 1.4 million students take out private student loans each year, though this number still pales next to the 12.9 million annual federal borrowers.

Private loans often fill the gap between the cost of school and the total financial package awarded to a student. What are the drawbacks? For starters, you’ll usually pay higher interest rates than on federal loans. Private loans also require repayment to begin immediately. While some lenders allow you to pay only interest, they do demand some sort of payment while you’re still in school—unlike federal loans.

In addition, there are far fewer protections with a private student loan. There are no deferment or forbearance options available to students who need help paying back their loan. Since the loan is only between you and the lender, it’s handled much like any other loan—and can affect your credit score after only one late payment. If you can’t pay back the loan, there’s a good chance that your wages will still be garnished, and you could be hounded by private debt collectors.

So what’s the best way to pay for college? With both federal and private loans having pros and cons, it can be a bit confusing deciding between the two.

My advice: Think first about the amount you need to borrow and what it’s for. If you need to borrow a large sum for tuition, a federal loan is probably the better option. You’ll see a lower interest rate—which means the loan will cost you less in the long run if it’s paid on schedule—plus the flexible repayment options could be a big help later.

Still, there are some occasions when a private loan is a good idea. Let’s say you have some specific, small expenses—such as a new computer or textbooks—and you’ll have the money to pay the loan off quickly. In that situation, a private loan could be the better option. If you find that, even after scholarships, grants and federal loans, you need yet more money, you might also check out private loans. But keep the drawbacks in mind.

Andrew Rombach is a content associate at LendEDU, a consumer education website with an editorial mission of improving financial literacy. Check out the LendEDU blog to learn about finance, read up on industry news or check out the latest data-driven studies.

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