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By Jennifer M. Zeberkiewicz
MoneyMix Contributor

If you're going to college and need student loans to help pay for it, repeat after me: I will exhaust my federal loan options and other sources of free money, such as scholarships and money that my parents and I have saved for my education, before I consider a private loan.

An analysis by the American Council on Education, Washington, D.C., found that one of five undergraduates with private loans didn't first take full advantage of federal loans—most likely because they were unaware of the differences between federal loans and private loans.

When selecting a private student loan, consider:

• The entire cost of the loan—fees and interest rate, plus any loan discounts

• Credit criteria and approval

• How often the lender will adjust interest rates

• Monthly payment requirements and repayment options

• Length of grace period and when repayment begins

• Deferment and forbearance options

• Reputation of the lender and customer service

A private student loan is a nonfederal loan that a lender such as a credit union or bank offers. Private student loans, also known as alternative education loans, help bridge the gap between the cost of your education and the amount you can receive in federal loans.

You can use private student loans for tuition, room and board, and other valid college expenses, such as study abroad. Private loans require a credit check before approval and generally have a variable interest rate. Financial institutions determine this rate and the term of the loan.

Federal student loans provide guaranteed approvals, flexible repayment options, and fixed interest rates due to government backing. That's why you should use private loans only after you've used money from federal loans, scholarship money, and college savings to pay for college.

As of February 2010, the Higher Education Opportunity Act requires that all private lenders include additional disclosure statements for private loan applications. Lenders must disclose the initial and maximum interest rate of the variable loan and compare them with federal loan rates before the student may borrow. The comparison can be an eye-opener because, at times, variable private student loan rates for qualified applicants are lower than federal loan rates.

the need for private loans

Though private loans should be a last resort when paying for college, many students need them. The amount of federal money that students can borrow is limited, and those limits have not kept up with inflation and tuition increases. As a result, some students have to rely on private loans to pay for expenses that their federal loans don't cover.

Private student loans typically have variable interest rates determined by common benchmarks such as the LIBOR (London interbank offered rate) or prime lending rates, plus a margin. The interest rate is based on the borrower's credit score—the better your score, the lower your rate. If a borrower has a co-signer, the borrower might receive a better rate if the co-signer has a high credit score.

"Private student loans got me through college," says Vince Passione, founder and CEO of Fynanz Inc, in New York. His company administers private student loans for credit unions nationwide. Passione's organization offers user-friendly private student loans. His organization and some others require a minimum monthly payment—$25 in his case—while borrowers attend school.

"By requiring them to pay while in school, the students are more familiar with how much money they are borrowing and how much money they'll have to pay back after college," Passione says. "By keeping in contact [with the lender], students start to educate themselves on financial responsibility."

The company considers a student's academic performance and grade level, as well as his or her credit score when determining rate. For example, a junior would earn a lower loan APR (annual percentage rate) than a freshman because the junior is that much closer to graduation and repayment. "There's a positive correlation between students who pay their loans back and get good grades," Passione says.

know your lender

It's important to investigate your lender before you take out a private loan.

Stacy, who works in the financial services industry, says she borrowed money for her college education through Stafford and private loans.

 Apply here for federal aid.

 Get answers to your questions about federal aid.

 Learn more about private loans.

"I knew the difference between federal and private loans, but I needed private loans to fill in the gap of what my Stafford loan didn't cover," she says. "A lot of students I went to school with didn't understand the difference—they just borrowed from whomever and got whatever loan they could to pay their tuition and other expenses. Some even used credit cards with 25% interest rates."

Fast-forward 10 years, and now Stacy is in repayment. She says the repayment options for her federal loans have improved during the past 10 years, but her private loan repayment options are very different.

"I feel like my private loan lenders make up their own rules as they go," she says. "My interest rate went up a lot, and it's hard to make ends meet. There's not a lot available if you have a financial hardship.

"I'm glad I got a private loan because I was able to graduate, but I just wish I knew then what I know now about compounding interest, grace periods, and forbearance [where a lender provides some temporary wiggle room on a loan]," she continues. "I also wish I paid while I was in school. It would have helped reduce my balance a lot."

When you compare lenders and loans, you'll likely find that credit unions offer the best deals. They generally have better interest rates, but shop around. Since credit unions are member-owned and not-for-profit, their cost of funds typically is lower than many banks'; they pass that on to members in lower interest rates on loans. "They tend to have higher approval rates because they know their members and can better assess their needs," Passione adds.

applying for a loan

If you decide you need private student loans, apply early. As the year goes on, lenders' capacity gets depleted and they may tighten their lending criteria, which can make less funding available, or it would cost more, Passione says.

Published February 8, 2011

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