Why You Should Never Take Out a Private Student Loan

by Emily Guy Birken · 16 comments

In 2001, I graduated from college with about $22,000 in student loans. The bulk of my debt ($20,000) was from a federal loan, but I also had a small $2,000 private loan.

Despite the fact that my private loan was a tenth the size of my federal loan, it was the much bigger headache producer in the year and a half it took me to get it paid off. My lender raised my payment once without notice, as well as increased my interest rate. Though my payment amount was low (about $60 per month), I decided to just quickly pay off the entire loan to avoid the stress-inducing changes that seemed to crop up every six months.

Thankfully, that was my only private student loan, and I’ve since paid off all of my loans. Some private loans, however, are more difficult to recover from.

Here’s the fine print you need to know about private student loans:

The Rates Aren’t What They Seem

You might be tempted to go for a private student loan over a federal loan because the advertised interest rates are so much lower. But remember, those ads are just that: advertisements intended to lure you into borrowing.

Private loans, unlike federal loans, require underwriting. That means the bank providing your private student loan will assess the risk of lending you money. Because of that, those low rates aren’t going to be available to every borrower — only those with the best credit. In addition, most private loans offer variable interest rates, rather than the fixed rates of federal loans. This is why my rate changed back in 2002.

You’re Putting Your Cosigners At Risk

Most private loans will also require a cosigner with the student. That means the cosigner (generally Mom or Dad) will be putting their credit at risk if Junior defaults. And a default is more likely, since private loans don’t offer the myriad repayment and deferment options available to federal student loan borrowers.

Grieving mother Angela Smith was in the news last year because her son’s private lender is intent on collecting the remaining $30,000 of his student debt from her — despite the fact that the young man was murdered in 2008.

Smith cosigned on a private loan with her son, and private lenders aren’t required by law to discharge a loan after a borrower dies. Unfortunately for Smith, it wasn’t made clear to her and her son that she’d be responsible for the student loan payment in the event of his death.

Even without a tragic end to a student’s life, cosigners are still in for potential collections calls and harassment — not to mention a hit to their credit — if the student finds herself unable to pay.

You May Fall Victim to Repayment Shenanigans

If you have more than one loan through the same lender, you might try to get your highest-rate private loans paid off first in order to maximize your payments. However, the Consumer Financial Protection Bureau has found that loan servicers (the companies hired by private lenders to collect payment) don’t always let you use this very sensible strategy.

The CFPB has found that servicers will often divide overpayment and apply it to all of the outstanding loans, meaning it’ll take the borrower longer to pay them back.

This is also a problem for any borrower who’s fallen behind in payment. Lenders will generally tell such a borrower to pay as much as they can afford — but that payment will be applied evenly to all of the loans, rather than just the highest-rate loan. This increases the late fees and other penalties the lender can place on the borrower, as well as worsen the impact on the borrower’s credit.

The Bottom Line

Private student loans can potentially be helpful in making the cost of college attainable. That being said, students are likely to have a better experience with federal student loans and should walk into a private student loan with their eyes wide open.

Do you (or did you) have private student loans? Have you run into any of these problems?

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{ 16 comments… read them below or add one }

David Ning June 9, 2014 at 10:16 am

Thanks for sharing Emily. I’d just like to add that variable rate loans are especially dangerous to take on now because the benchmark rates are at historic lows and there’s a very good chance that it’ll go up in the future.

Private loans have its place, but use caution before jumping in with both feet.

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Phil June 9, 2014 at 12:56 pm

While I can’t talk too much about private vs regular student loans I would like to give my two cents on any kind of student loan:

1. They should be bankrupt-able, like everything else out there. I will never understand how every other type of lending is bankrupt-able, but student loans are protected. Additionally, it will help to drive DOWN the cost of college overall.

2. If you can avoid it, just don’t take out any student loans. Go to a public, in state college. Better yet, go to a community college for the first two years. Work your a*$ off while in school. Graduating with little to no loans will set you up for the rest of your life. Rather than making payments, you can make investments. That money will compound for you greatly the sooner you start.

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David Ning June 9, 2014 at 3:11 pm

On some level, I agree with you that we shouldn’t give special treatment to any particular type of loan, but allowing student debt to be easily erasable is dangerous. If you can simply declare bankruptcy to eliminate such a big obligation, wouldn’t the prudent strategy for most graduates be to just declare bankruptcy on their final year of college as soon as they get their last student loan payment? Can you imagine many medical students doing that with their hundreds of thousands in student loan debt, and what that will do to interest rates?

Then again, if student loan rates are on par with other types of unsecured debt, then it might be so high that no one would be willing to borrow and thus, like you said, ultimately drive down the cost of college because people aren’t willing to pay the high prices anymore.

It would be painful for quite a few years while the prices adjust but there’s a certain brilliance in the strategy! :)

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Brenda @SuperMoney June 9, 2014 at 2:46 pm

I admit, I wasn’t very money-wise when I was in college. There wasn’t a day that passed when I didn’t see a commercial for Chase or Sallie Mae loans, and I made the mistake of getting a few small loans with my husband to help with expenses, as we were both super-full time. Worst idea of my life, and if I could go back in time, I’d kick myself and burn the applications.

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David Ning June 9, 2014 at 3:13 pm

Don’t kick yourself too much. While you hate the payments and probably calculated how much farther you would be ahead without the debt obligations, you learned a good lesson that will pay dividends forever because you’ll limit spending because you hate debt so much.

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Dee @ Color Me Frugal June 9, 2014 at 3:46 pm

Thankfully I never had private student loans, but I’ve had plenty of federal student loans to make up for it! I have heard all sorts of negative things about them (pretty much everything you mentioned above) and I think I’d advise anyone to avoid them for that reason. I’m not fond of my federal student loan debt, but at least my interest rate is fixed and I didn’t have to have a parent co-sign!

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David Ning June 9, 2014 at 9:36 pm

Good for you Dee. Be happy with the fixed rate because there are fewer curve balls when the payment amount is known and fixed.

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Michelle June 10, 2014 at 9:14 am

I have multiple private student loans. They allowed me to work towards a Masters degree, but they are a pain. I tried to consolidate them but was unable to.

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David Ning June 11, 2014 at 10:53 am

Another alternative is to pay minimum on all the loans while aggressively pay down the smallest loan. You’ll reduce the number of payments, though you may end up paying a bit more in interests versus paying the highest interest rate loan first.

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Aldo R @ MDN June 10, 2014 at 9:48 am

I think is terrible that private student loans don’t die with the person. That’s a double whammy for grieving families.

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David Ning June 11, 2014 at 10:54 am

Help me understand Aldo. Why would grieving families be obligated to pay off a decease person’s loan if they didn’t sign for it? And if they did, then it’s THEIR loan right?

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Ryan June 10, 2014 at 8:43 pm

I have mine through the only state run bank in the nation, Bank of North Dakota and they are fantastic! Never had any run around, I got a great rate, and I get $1,500 a year forgiven for 4 years if I remain employed in the state, so awesome! North Dakota, believe it or not, does bureaucracy right. That and North Dakotans and the state are so highly adverse to debt, very virtuous!

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David Ning June 11, 2014 at 10:56 am

Nice. North Dakota does many things right for sure and I’m happy to hear that you are taking full advantage!

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Jim June 12, 2014 at 7:53 am

There is one section of this article that doesn’t make sense to me.

“And a default (on private loans) is more likely, since private loans don’t offer the myriad repayment and deferment options available to federal student loan borrowers.”

Defaults for the federal program have never been higher, while many of the new (start ups in the PSL space) private lenders are seeing less than 1 percent delinquency rates and no defaults. The underwriting (a statistical analysis of your ability to pay back a loan) being the exact thing that makes this possible. The federal loan program, meanwhile, does not underwrite loans and sees a very high number of defaults and delinquencies. Between 2004-2009, only 37% of borrowers even managed to make all of their payments on time. 63% of borrowers can’t pay their loans on time, but you’re less likely to default on federal loan? 41 percent or borrowers enter delinquency during the first 5 years of the loan. Apologies, but the numbers don’t add up.

http://www.asa.org/policy/resources/stats/

Should borrowers still exhaust their federal options before going private? Absolutely. Borrowers need to plan carefully about their future before taking out ANY student loan. Not just private ones.

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David Ning June 12, 2014 at 2:29 pm

I believe Emily is talking about someone being more likely to default on the federal loan if they have BOTH private and federal student debt because logically, federal loans having more flexible payment terms would help borrowers keep paying.

The numbers you show are the loans in aggregate, and show just how much better loan performance are with proper underwriter. This is debatable because I don’t have the numbers in front of me but I suspect that those who default on their federal loans also default on their private ones, assuming they have both.

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Caleb July 3, 2014 at 7:35 am

There are responsible ways to handle a student loan. For many individuals, including myself, a loan might be the only option for getting through school. They can be definitely worth it and there are smart ways to utilizing a student loan in your favor.

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