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Loan Tradeoffs - Public vs. Private


Parents who are looking for a loan for their children's education have many choices, including:

Regardless of which option the family chooses, they should always consider using up any remaining unsubsidized Stafford loan eligibility before tapping into the other types of loans.

There are several tradeoffs among these options.

  • Interest Tax Deduction. Home equity loans and lines of credit are tax deductible, if the taxpayer itemizes deductions on Schedule A of the 1040. This includes the interest on up to $100,000 of a HELOC used to pay for items other than improvement of the home, such as paying for college. On the other hand, the taxpayer can deduct up to $2,500 a year in student loan interest even if he or she doesn't itemize. (The student loan interest deduction is an above-the-line exclusion from income and as such reduces the adjusted gross income (AGI). The income phaseouts and other eligibility requirements for the student loan interest deduction and the home mortgage interest itemized deduction differ and may make one option better than the other for some taxpayers.)

  • Responsible Party. The parent is responsible for repaying the PLUS loan. The student is not responsible for repaying the PLUS loan, although many parents enter into agreements with their children to have them make the payments on the loan. In contrast, many alternative loans make the student responsible for repaying. However, those loans often require the parent to cosign the loan, making the parent responsible for repaying if the student should fail to make timely payments on the loan.

  • In-School Deferments. Many alternative loans allow the parent to defer payments while the student is in school and for a short grace period after graduation. The Ensuring Continued Access to Student Loans Act of 2008 gives parents the option of deferring repayment while the student is in school and for a six month grace period after the student graduates or drops below half-time enrollment. (This change is effective for Parent PLUS loans originated on or after July 1, 2008.) In both cases deferring payments substantially increases the size of the loan since interest continues to accrue and is added to the loan balance when the loan enters repayment. See below for a discussion of options for relief for borrowers who are encountering financial difficulty. You can also obtain economic hardship deferments and forbearances on a PLUS loan. There are no similar benefits on HELOCs and home equity loans.

  • Interest Rates. The interest rate on the PLUS loan is often lower than the rates on home equity loans, although both rates are in the same ballpark. The PLUS loan is also less expensive than most private student loans. The PLUS loan interest rate is fixed while private student loans and home equity lines of credit typically have variable interest rates. The current interest rates on a HELOC might be lower, but this can change over the life of the loan. (While private student loans might advertise rates that are lower, these rates are available only to the best credit customers. These rates also don't consider the higher fees associated with private student loans. Most borrowers pay a much higher interest rate and fees. One must also be concerned about how the rates might change over the life of the loan, which is typically a 20 or 25 year obligation. If the borrower intends to repay the loan in full only a few years after disbursement, then a variable rate that is temporarily lower might be ok. But otherwise the borrower should beware of teaser rates that will disappear when the variable interest rate indexes start increasing. Note, however, that no interest accrues on subsidized loans during the in-school period, so the Perkins loan and subsidized Stafford loan are still superior.) PLUS loans typically offer an interest rate discount of 0.25% if you agree to have your monthly payments automatically deducted from your checking account.

  • Loan Term. The loan term on a PLUS loan is 10 years while the term on a HELOC is typically 10 or 15 years. However, you can get extended repayment of up to 25 years on a PLUS loan if you have more than $30,000 in federal education debt with a single lender. You can also consolidate the loan to get access to alternate repayment plans such as extended repayment of up to 30 years. The loan term on a HELOC could potentially be extended up to 30 years by refinancing the first and second mortgages into a 30-year fixed mortgage.

  • Availability. About 70% of parent and graduate/professional student borrowers will qualify for a PLUS loan. The adverse credit history requirement is not as stringent as the criteria used for private student loans. Subprime borrowers (borrowers with FICO scores under 650) will generally not qualify for most private student loans. Note that PLUS loans and unsubsidized Stafford loans are available without regard to financial need.

  • Impact of Default. If one defaults on a federal education loan, the government can garnish wages and social security payments, and attach income tax refunds. Student loans are generally not dischargeable in bankruptcy. On the other hand, if you default on a home equity loan or line of credit, the lender can take your home.

Although borrowing from your retirement plan has the benefit of paying the interest to yourself, this is merely a substitute for the money it would have earned from being invested. There are also significant restrictions on borrowing from your retirement plan. If you don't repay the money on time, it can lead to severe tax penalties. Interest paid on the loan is not tax deductible. Generally speaking, borrowing from your retirement plan is one of the worst options available.

If you are pursuing an alternative loan because of bad credit, you should consider applying for a PLUS loan anyway. If you are denied a PLUS loan for credit reasons, your child becomes eligible for higher Stafford loan limits.

Options for Relief for Borrowers Encountering Financial Difficulty

This chart illustrates some of the main options for relief for borrowers who are encountering financial difficulty.

Options for ReliefFederal LoansPrivate Loans
Extended Repayment 10 to 30 years In limited cases, 15 to 30 years. Most lenders already at max term of 20 or 25 years.
Graduated Repayment Yes No
Income-Contingent Repayment Yes No
Income-Sensitive Repayment Yes No
Income-Based Repayment Starts July 2009 No
Loan Forgiveness Programs Yes No
In-School Deferment Yes, unlimited Yes, limited
Economic Hardship Deferment Yes, 3 year cap No
Forbearance Yes, 3 year limit Yes, 1 year limit
Closed School Discharge Yes No
Discharge for Death of Student Yes No (a few exceptions)
Discharge for Student Borrower's Total and Permanent Disability Yes No
Bankruptcy Discharge Undue hardship Undue hardship

Why do people borrow private student loans instead of federal education loans?

Given that the Stafford and PLUS loans are less expensive than most private student loans, why do some families seem to prefer the private student loans? For example, 91.1% of undergraduate private student loan borrowers do not borrow from the PLUS loan program (89.1% at 4-year institutions), 22.7% do not borrow from the Stafford loan program (19.5% at 4-year institutions) and 21.7% did not borrow from either program (18.4% at 4-year institutions), based on FinAid's analysis of the 2003-04 National Postsecondary Student Aid Study. Among the undergraduate students whose parents did not borrow from the PLUS loan program, 12.9% did not apply for federal student aid (11.6% at 4-year institutions). Among the undergradaute students who did not borrow from the Stafford loan program, 51.8% did not apply for federal student aid (53.4% at 4-year institutions). Among undergraduate students who did not borrow from either the Stafford or PLUS loan programs, 54.2% did not apply for federal student aid (56.6% at 4-year institutions). This compares with 88.2% of private student loan borrowers applying for federal student aid (89.6% at 4-year institutions).

While there aren't any credible studies of why some families seem to prefer private student loans, anecdotal evidence suggests the following reasons:

  • Lower monthly payments. Most private student loans have a 20 or 25 year loan term, which results in a lower monthly payment than the standard 10 year term of a federal education loan despite the higher interest rate. For example, the monthly payment on a $20,000 Stafford loan at 6.8% interest with a 10 year term is $230.16, compared with $203.72 on a $20,000 private student loan at 10.8% interest and a 20 year term. So even though the total interest paid over the life of the loan is almost four times as much ($28,895 on a 20-year 10.8% loan compared with $7,619 on a 10-year 6.8% loan), the private student loan might seem to be more affordable due to the lower monthly payment. While one could obtain a longer loan term by consolidating the federal education loans, this requires taking an additional step. The idea that they'll still be paying off their own student loans by the time their children enroll in college doesn't seem to matter as much as paying less money per month.

  • Better marketing. Private student loans are more profitable to the lenders, so there is more of an incentive for the lenders to promote private student loans. Private student loans are often advertised with teaser rates that are competitive with the PLUS loan program, such as rates for borrowers with excellent credit. Non-school-certified private student loans (also known as direct-to-consumer loans) bypass the college financial aid office, so borrowers of these loans might not be obtaining advice from the college concerning the higher cost of private student loans.

  • Bureaucracy and Privacy. Applying for a private student loan is much simpler than applying for federal education loans. In particular, one must file the Free Application for Federal Student Aid (FAFSA) in order to apply for the Stafford loan. (While a FAFSA is not required for the PLUS loan, in practice most families believe that the FAFSA is required for all federal education loans.) Families who do not qualify for other forms of federal student aid do not like being required to file the FAFSA. Besides an aversion to the extra paperwork and the invasive nature of the process, families often have concerns about the privacy of FAFSA data. They don't like disclosing personal data to the federal government. Divorced parents are also often concerned that their ex-spouse may somehow get ahold of their financial information. (In a few cases the custodial parent does not complete the FAFSA in an attempt to hurt the non-custodial parent, who may have a college support obligation.)

  • Confusion between federal and private loans. Since federally-guaranteed loans are offered by private lenders who also offer private student loans, some borrowers may be confused concerning the difference between the loan programs.

  • Familiarity. People feel more comfortable with their local home-town bank and are more likely to follow their recommendations even if it is for a higher cost product.

  • Lack of awareness of differences in cost. While many students and parents seem to be generally aware of the higher cost of private student loans, few seem to be able to quantify that difference in concrete terms, such as the total interest paid over the life of the loan or interest rates that are about 4% higher on average. Families who have calculated the total cost of the loan are less likely to borrow private student loans before exhausting their federal education loan options.

  • Confusion about eligibility. Some families incorrectly believe that a high EFC makes them ineligible for federal education loans. Middle and upper income families are more likely to borrow from private student loan programs; they may have assumed that their incomes are too high for federal student aid. These families are not aware that the unsubsidized Stafford loan and the PLUS loan are available without regard to financial need. A few families do not initially file the FAFSA and then assume that they are ineligible for federal education loans because they missed the state or school deadlines for non-federal aid.

  • In-School Deferments. Parents often want to be able to defer payments while the student is in school. Previously, the PLUS loan program would only allow deferments when the parent is in school, not when the student on whose behalf the loan was borrowed is in school. This oversight was corrected by the Ensuring Continued Access to Student Loans Act of 2008, which provides parents with the option of deferring repayment while the dependent student is in school and for a six month grace period after the student graduates or drops below half-time enrollment. (Previously, a handful of lenders worked around this limitation by offering administrative forbearances while the student is in school.)

  • Stagnant annual and cumulative Stafford loan limits. Congress increased the annual Stafford loan limits for freshmen by $875, sophomores by $1,000 and graduate students by $2,000 on July 1, 2007 without any increases in aggregate limits. Congress also increased the annual unsubsidized Stafford loan limits by $2,000 for undergraduate students on July 1, 2008 and increased the aggregate limits for unsubsidized Stafford loans by $8,000 for dependent undergraduate students and by $11,500 for independent undergraduate students. These were the first increases in annual and aggregate Stafford loan limits since 1992. These increases will shift some borrowing from private student loans to federal student loans. But still, the loan limits are small and not indexed for inflation, so students will continue to max out their Stafford loan eligibility. When students max out the Stafford loans, they are forced to choose between the PLUS loan program and private student loans. The additional unsubsidized Stafford loan limits for independent students and students whose parents were denied a PLUS loan are also insufficient. Compared with the cost of college, the current Stafford loan limits are insufficient.

  • Preference for student borrowers. Some parents are unwilling or unable to borrow from the PLUS loan program. The federal need analysis methodology does not consider consumer debt. Parents who are already up to their ears in debt don't want to take on more debt, especially when this may affect their eligibility for a mortgage, auto loan, or credit card. Some students prefer student loans because of a sense that their parents have "done enough".

  • Failure to make Satisfactory Academic Progress. Students who are not making Satisfactory Academic Progress (SAP) by maintaining a minimum 2.0 GPA are ineligible for federal student aid, including federally-guaranteed loans. Such students have no choice but to borrow from private student loan programs if they wish to continue their education. Students who are enrolled less than half-time and international students are also ineligible for federal student loans.

  • Institutional eligibility. Among private student loan borrowers attending less-than-two-year programs, 90% of those who do not borrow from federal education loan programs are enrolled at for-profit institutions. While this represents less than 5.0% of all private student loan borrowers who don't borrow from federal education loans, it does suggest that some students borrow from private student loan programs because they attend institutions that are not eligible to participate in federal student aid programs. (Schools with a cohort default rate of 25% for three years in a row or 40% in any single year are ineligible, as are unaccredited institutions.) Curiously, 37.5% of private student loan borrowers who don't borrow federal education loans attend public 4-year institutions, 23.9% attend public 2-year institutions and 17.9% attend private non-profit 4-year institutions. Overall, 57.6% attend 4-year institutions, 26.8% attend 2-year institutions, and 5.5% attend less-than-2-year institutions. (10.1% attended more than one type of institution.)


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