A Guide to Navigating Private Student Loans

Congratulations! After years of hard work, you have been accepted into the college of your choice. You are so excited that you can’t help but celebrate…until you see your first tuition bill.

These days, getting into a good college is only half the battle; the other half is figuring out how to pay for it. Even if you are fortunate enough to be granted a partial scholarship, there is often a large difference between what the school covers and what you owe.
After scholarships, you may turn to federal student loans, because they typically have lower interest rates and do not require credit or income checks; however, the annual borrowing limits on federal student loans can be so low that you may need more financing.1

This is where private student loans can come into play — a final option after you have exhausted scholarships, grants and federal student loans. Private student loans should be used as a last resort because they carry many risks, including higher interest rates than federal loans and less flexibility and repayment options if you become unemployed or are unable to make payments for any reason.2

Once you discover that you need to shop around for alternative financing options, you may find that only a small portion of your tuition needs to be dedicated to private loans. Regardless, the process of selecting a private loan can make you feel like you are navigating uncharted territory, while drowning in a sea of confusing financial jargon. While your school’s financial aid office can be a good resource, the overwhelming amount of options and providers available can make it difficult to determine whether you are signing for the best loan relative to your needs.

Whether federal or private, signing for a loan is the same as signing a contract — and the terms are just as binding. Therefore, it is imperative that you have a complete understanding of the terms of the loan prior to signing. Before you meet with a loan lender or your school’s financial aid office, consider preparing a list of questions and specific features that you’re looking for in a private loan.

Private Student Loans

The following loan features can provide a good starting point:

Interest Rates

When it comes to loans, interest rates typically receive the most hoopla. That is because the interest rate is one of the most important features to compare when you’re evaluating loans.

Let’s look at a completely hypothetical example: imagine that after all of your scholarships, grants and federal loans, you still need to finance $20,000 of your tuition for your freshman year. One morning, you get up early, dress nicely in your only unwrinkled outfit and head down to your two friendly, neighborhood banks. Both banks perform credit checks and ultimately approve you for a loan. Bank A offers you the loan at a six-percent interest rate, while Bank B offers you the same loan at a 5.9-percent interest rate. After one year, you will owe $1,200 in interest with Bank A’s loan or $1,180 in interest with Bank B’s loan.

While $20 may not seem like a big difference, remember that we only looked one year into the future — over a four-year period, this can result in an approximately $100 difference in interest rates. It’s important to remember that you’re comparing interest rates that last over the entire life of the loan so be sure to evaluate the potential costs accordingly before signing on the dotted line.

Some loans also include a feature called capitalization, which allows the borrower to opt out of making interest payments while in school in favor of adding the accumulated interest to the total principal balance of the loan. Although this option can be useful if you cannot afford to pay interest while attending school, that increase in loan principal also increases the amount of interest that will accumulate until the loan can be paid in full.
To see this in action, let’s refer back to our previous hypothetical example: under capitalization, the principal on the loan offered by Bank B would no longer be viewed as $20,000, but as $25,154.39; interest would build on that value instead of the original $20,000.

This balance change affects the way interest grows over time because of the way loan payments are structured. Fixed loan payments go toward paying off both principal and interest, but not equally. In the early years of a loan’s life, most of a borrower’s payment goes toward interest, with only a small portion chipping away at the principal. By the end of a loan’s life, most of the payment goes toward the remaining principal; therefore, the interest portion is lower because the principal balance has been shrinking (six percent of $100 is less than six percent of $200.) Therefore, tacking more money on to your principal balance before you start making payments means the principal will take longer to pay off and can ultimately allow more interest to grow. Carefully consider your situation and needs before agreeing to capitalization.

If you already have a private student loan and feel that you are paying too much due to its high interest rate, it could be time to consider refinancing the loan. It may be possible for you to secure a lower interest rate with another bank or swap your variable interest rate for a fixed interest rate. Loans do not always have to be a sign-and-done deal; regularly reviewing your loan for possible refinancing could save you a significant amount of interest over the long term.

Fees and Penalties vs. Benefits

Believe it or not, your friendly neighborhood banks from the previous example may be sneaking fees into your private loan agreement, including origination fees at the start of the loan to cover costs associated with processing the agreement. Private loan lenders may also have consequences for missed payments, such as late fees and interest rate increases.3

On the other hand, banks may offer extra incentives to encourage the borrower to make timely payments, such as decreasing the loan’s interest rate. You are more likely to qualify for these benefits if you make payments on time, sign up for automatic payments from your bank account or simply graduate college.4 Be sure to take fees, penalties and benefits into consideration before deciding on a loan.

Cosigner Release

Since college students typically have little to no credit history, a cosigner may be required for you to receive approval for a private student loan. Some loans have a feature that will release the cosigner from the loan’s obligation after a certain period of time.5 If this feature is important to you and your prospective cosigner (your parents, older sibling or another family member), research the requirements for cosigner release when comparing loans.

Deferments and Prepayments

Deferments can allow you to temporarily postpone (or defer) payments if you continue your education and attend graduate or professional school. Prepayments allow you to make early or additional payments in order to pay off the loan more quickly.6

The prepayment feature is very useful because it decreases the amount of total interest that will accumulate over the life of the loan, thus decreasing the total amount of money coming out of your pocket. However, keep in mind that some banks place a penalty on prepayments to prevent the loss of future interest payments. Evaluate your loan contract carefully to see whether your lender employs this stipulation.

Customer Service

Loans can be complex, and potential borrowers tend to have a lot of questions.
New questions or problems may also arise over the course of the loan, such as a lost bill or statement error. Mistakes happen, which is why customer service can be a huge help. Before signing a loan, you may consider visiting the bank’s website ahead of time and ensure you have their customer service information on hand, should you run into any issues or have questions in the future.

It is easy to forget that paying for college is an investment that can provide substantial returns many times over in the form of wages. Make sure that you are well-informed before you navigate the private student loan market to help ensure you get the best marginal return on your future!

 

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
OneBite Editorial Staff
OneBite Editorial Staff

OneBite® is a Top 50 Financial Advisor Blog powered by Hewins Financial Advisors. Founded in 2011, the digital magazine is dedicated to providing intelligent, in-depth coverage and analysis of the top financial and economic issues facing investors today.

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A Guide to Navigating Private Student Loans

time to read: 6 min