What Are the Risks of Private Student Loans?
Updated August 18, 2022 • 4 min read
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If it were up to Mark Kantrowitz, a student loan expert, each private student loan would come with caution tape.
Why? Because private student loans are risky compared to federal loans – especially for incoming college students.
"Private loans don't have the same protections as federal loans," he said. "The other thing is you have a 17-year-old making financial decisions who probably has never had any experience with debt of any kind, let alone $10,000, $20,000, $30,000 in student loan debt."
College students who need help paying for college borrow two types of student loans: federal and private. Most students start with federal loans because they usually offer lower interest rates and have more flexible repayment options than private student loans.
But the government limits federal borrowing, so some students take out private loans to fill funding gaps that federal student loans don't cover. Others, such as graduate students, rely heavily on private loans to pay for school.
Private Student Loans vs. Federal Student Loans
- Private student loans come from lenders such as banks, credit unions, state agencies, or schools. Each lender sets its terms and conditions for repayment.
- The federal government funds federal student loans. Terms and conditions of repayment get set by law.
Regarding the student debt crisis, most of the total education debt is in federal student loans. Private student loans represent only about $138 billion — 8% of the total $1.7 trillion.
But private student loans are harder to repay for several reasons.
Since the government does not issue private student loans, they're ineligible for federal programs that make it easier to pay off student loans. Taking out nonfederal loans means no income-driven repayment, Public Service Loan Forgiveness, or loan rehabilitation programs.
Private student loans come with other serious drawbacks compared to federal loans, including:
- Higher interest rates;
- Limited repayment terms;
- Shorter default period;
- Interest rate accrual; and,
- Default after one missed payment.
During the COVID-19 pandemic, private student loans have been left out of federal relief programs that help borrowers with financial uncertainty, leaving students reliant on private companies' policies for relief. And many lenders do offer coronavirus relief or student loan forbearance — but not all of them.
Despite private student loans being riskier than federal student loans, data shows private student loan debt is relatively stable – even during a rise in unemployment caused by the virus.
According to MeasureOne, which reports on the student loan market, borrowers successfully paid more than 98% of private student loans as of September 2020. Meanwhile, delinquencies, defaults, and forbearances are at long-term lows. The number of loans in distress – meaning a loan in forbearance that is 30 or more days past due – is well below the levels seen in the Great Recession, though still higher than normal due to the pandemic.
Repayments are stable partly because lenders have provided payment relief solutions to distressed borrowers, but it can also be explained by who is taking out private loans and why.
According to Kantrowitz, "Borrowers who borrow private student loans are credit underwritten, meaning that they're much less likely to default and much more likely to be able to repay the debt."
Underwriting is a process the lender uses to assess the borrower’s ability to repay the loan. Lenders may or may not approve a loan if a borrower is likely to default. In other words, people who get approved for private loans tend to have strong credit scores and more access to capital, putting them in a better position to repay.
Kantrowitz also said many borrowers take out expensive loans to attend top schools, knowing their future income will make them better able to repay the debt. But there's a flip side to consider.
Without the safety net that federal student loans provide, private loans can become riskier if borrowers overextend themselves. While there are borrowing limits for both federal and private student loans, private student loans typically offer a higher maximum amount.
"The key, though, is did you borrow too much money?" Kantrowitz said.
Evan Thompson is a Washington-based writer for TBS covering higher education. He has bylines in the Seattle Times, Tacoma News Tribune, Everett Herald, and others from his past life as a newspaper reporter.
Header Image Credit: Image Source | Getty Images
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