Borrowing money to pay for college has become the norm for many young adults these days, with total student loan debt in the U.S. topping $1 trillion. While most of that consists of federal loans, students are also borrowing from private lenders to the tune of approximately $165 billion.
While private loans can help to fill in the gaps in funding when you max out your federal loan eligibility, they’re not without certain pitfalls. Private lenders operate very differently when it comes to things like loan approval and repayment options, which can come as a surprise to students who haven’t done their research beforehand. We’ve got the skinny on six private student loan facts that lenders don’t always share.
1. Good credit counts
When you apply for federal student loans, the Department of Education considers financial need to decide how much aid you qualify for, if any. Private lenders, on the other hand, tend to function more like banks which means they take a close look at your credit before you approved. If you’re headed off to school for the first time, you’ll likely need to bring in a co-signer. Older students may qualify for loans on their own if they’ve managed to build up a decent credit history.
Aside from determining whether you’re even able to get private student loans, your credit also comes into play when the lender sets the interest rate. Just like with a credit card or another type of loan, the better your credit is the lower the rate will be.
If you know you’ll need a co-signer, you should choose someone who’s got a high credit score and a low debt-to-income ratio to make sure you get the best rates. Students who plan to fly solo with private loans can improve their scores by paying all of their bills on time, keeping the balances on their other debts low and limiting how often they apply for new credit.
2. Extra payments aren’t automatically applied to the principal
Throwing a few extra dollars a month at your loans is an excellent way to speed up your repayment and maybe even save a little on the interest but it doesn’t help if your lender’s not applying the payments correctly. Instead of the additional money going towards the principal, the lender just counts it as your next month’s payment and marks your account as being “Paid Ahead.” While that can help you out if you fall behind one month, it doesn’t benefit you as far as saving on interest.
Even if you make it clear to the lender that anything above your minimum should go towards the principal, you can’t count on them applying it to the loan with the highest interest rate. The problem, according to the Consumer Financial Protection Bureau’s 2013 annual report, is a lack of uniform standards regarding how extra payments should be divvied up. Any time you plan on paying more towards your loans, you need to be explicit with your lender about how the funds should be used to get the most benefit possible.
3. Variable rate loans aren’t always the better deal
Federal student loans have fixed interest rates, which means they never increase over the life of the loan. With private loans, you have the option of taking a variable rate instead. A lot of students find the variable rates more attractive, since they tend to start out lower than the fixed rates but that doesn’t guarantee that you’ll pay less for the loans. If the rate fluctuates significantly, it could actually end up costing you more than the fixed option.
For instance, let’s say you have one loan with a $10,000 balance. You can go with a fixed rate of 6.49 percent or a variable rate starting at 3.99 percent. Assuming a 20-year repayment term, you’d end up paying just under $20,000 over the life of the loan. Now, if you go with the variable rate and it increases by 5 percentage points, that $10,000 will end up being closer to $24,000 by the time it’s all said and done. When you’re weighing your options, you need to be clear on what the maximum cost could be if you decide to go with a variable rate.
4. You could be sued if you don’t pay
The biggest danger of getting behind on your private student loans is having your loan servicer come after you for what’s due. Since they’re not backed by the federal government, private lenders can use wage garnishment or bank account seizure to force you to pay up. Not only does that put whatever assets you might have at risk, but it also goes against your credit. Fortunately, more lenders are stepping up to offer help to struggling borrowers.
On the heels of a CFPB report which found that private student loan complaints increased by 38 percent between 2012 and 2013, both Wells Fargo and Discover announced that they’d be making modification programs available to grads who are having difficulty making their payments. If you’re going through a financial hardship, it’s worth it to call up your lender to see if a modification of your loan terms is possible.
5. Bankruptcy isn’t a guaranteed escape
There are a lot of misconceptions about student loans and bankruptcy and one that seems to be most common is that it’s relatively easy to wipe out your private loans by going this route. The reality is that discharging private loans in bankruptcy requires you be able to prove that you absolutely cannot afford to pay anything towards the debt, which can be very hard to do. Unless paying the minimums would make it impossible for you to cover basic living expenses, like rent, utilities and food costs, you shouldn’t count on an automatic discharge.
If you’re on the verge of defaulting, avoiding your lender is the last thing you want to do. Instead, you should be proactive about letting them know what’s happening financially and looking into a modification or forbearance, which can give you a temporary break from making payments.
6. Your loans can haunt your loved ones after you die
Federal loans include a provision that discharges any remaining balance if the borrower dies but private loans don’t come with that same protection. If you took out loans with a co-signer or you’re married and live in a community property state, your loved ones would be on the hook for anything you still owe if something were to happen to you unexpectedly.
There are a couple of things you can do if you’re worried about leaving their relatives responsible for their student debt. If someone else helped you take out the loans, you could ask your lender for a co-signer release, provided you can prove that you’re financially able to handle the payments on your own. When that’s not an option, you might want to think about taking out a life insurance policy to cover whatever you owe so no one else is left holding the bag.