What Are Private Student Loans?

Sending your child off to college can evoke a mixture of emotions, from pride, satisfaction and maybe even nostalgia. But it can also come with a bit of angst: How will they cope with their new schedule? Will they like their roommate? And, maybe the most daunting question, how will you pay for it all?

While savings, federal student loans, grants and scholarships may help you have a big chunk of the cost, a private loan can help make up the difference. But before you sign on the dotted line, here’s what to know about using a private student loan to pay for college.

WHAT ARE PRIVATE STUDENT LOANS?

Private loans are exactly what they sound like — loans made by private organizations like banks, credit unions or other financial services providers, rather than the federal government. You can take them out in your own name, co-sign with your child or if he or she has the creditworthiness, your child might be able to get a loan on their own.

Unlike federal loans, which have standardized interest rates and repayment plans, each lender sets different terms and payments for private loans, which may have a variable or fixed interest rate.

Another difference is that to take out a private loan, you first need to undergo a credit check. This can be an advantage if your credit is strong, because you may be able to secure a better rate.

WHAT ARE THE POTENTIAL DRAWBACKS?

While private loans can be a solution for a college funding dilemma, there are a few things to consider before taking one out:

You could face higher costs. Without good credit, you could end up paying more interest than you would with a federal loan. As you research your options, be sure to carefully compare the rates and terms from a variety of lenders so that you fully understand the fees, repayment options and the potential penalties.

You could hurt your creditworthiness. Whether you’re the sole borrower or co-signer, taking out a private loan could affect your ability to borrow money for your own needs in the future. That’s because taking on a loan means increasing your total amount of debt. If you ever decide to apply for a mortgage or other line of credit, the lender will evaluate your debt-to-income ratio (or the amount of money you owe compared to your income) when deciding how much money to approve you for, and these payments will be a factor.

Plus, if you decide to co-sign a private loan, you are legally responsible for the entire amount, if your child can’t pay the loan themselves. In addition, if your child was to pass away, you may owe the entire balance of the loan immediately. It’s a good idea to discuss the full financial obligation and responsibilities you expect your child to uphold before taking out a private loan.

You could end up neglecting your savings. As a parent, you may be wondering if you should save for college or retirement. From a purely financial perspective, funding your future should always come before your child’s education. Ensure you have a plan for your retirement savings in place before tackling paying for college — a financial advisor can help you with this.

WHAT ARE SOME ALTERNATIVE OPTIONS?

If you ultimately decide not to take out a private loan, there are some additional options to help you pay for college.

Consider a different type of loan. In addition to financial aid, the federal government also offers Direct PLUS Loans, also known as parent PLUS loans. While these provide some of the same benefits as federal loans, you’re likely to get a better rate with a private loan if your credit is good.

The cash value of permanent life insurance. If you or your child has a permanent life insurance policy that has accumulated cash value, you may be able to tap into the policy’s cash value either through a loan, partial surrender or full surrender of the policy. This could be an additional source of college funding. Before going this route it’s a good idea to work with your financial advisor as taking loan will reduce your death benefit. Additionally, surrendering your policy could have negative tax consequences.

Rethink your school of choice. Taking on debt to pay for college is not a decision that should be made lightly, so be sure to fully weigh if the cost of your child’s desired school is worth it. You may ultimately decide that a less expensive institution makes more sense for you and your family.