Chances are you are one of the 44 million Americans affected by student loan debt. Many people find themselves dealing with these financial obligations as a necessity as tuition rates climb, the cost of living increases, and having a college degree determines our potential for success.
Understanding the difference between private and federal student loans can better prepare you for repayment. Furthermore, knowing how these two types of loans can affect your credit score will better secure your financial well-being.
Federal Loans Benefits
In America, the U.S. Department of Education has created a student loan program, offering loans with more benefits than private or bank loans. These benefits include:
- Income-based repayment options
- Fixed interest rates
- Deferment options
- Interest rate reduction
Many federal student loans also don’t require a credit check.
With many private loans forgoing these types of benefits, it is widely accepted as a smart choice to deplete all possible federal options before looking to private loan options. The types of federal loans include:
- Subsidized: The federal government provides these types of loans for individuals with financial need. Based on the information you provide on your Free Application for Federal Student Aid (FAFSA), your school then determines the amount you may borrow based on need. The primary benefit of these types of loans is the U.S. Department of Education pays the interest on your loan:
- While you are still enrolled at least half time.
- During a six month grace period following graduation.
- During deferment periods.
- Unsubsidized: These types of loans get offered by the government, but do not depend on financial need. Your school still determines the amount you may acquire based on your cost of enrollment. The most significant major difference between the unsubsidized and the subsidized is that the borrower is responsible for paying the interest of the loan the entire time the loan remains unpaid. This includes any amount of time the loan may be in deferment.
- Direct PLUS loans: These are alternative loans provided by the U.S. Department of Education. Their purpose is to cover any extra costs other loans are unable to cover. They are not based on financial need and require good credit to receive. Because of this reason, many students without credit will require a co-signer. There are cases where negative credit applicants can receive these types of loans, but other information must undergo evaluation for approval.
- Direct Consolidation Loans: When you find yourself with multiple types of federal loans, sometimes it helps to have them combined into one lump sum. The Direct Consolidation Program allows borrowers to take any federal loans and connect them with a fixed interest rate. The rate gets determined by taking the average interest rate from all other repayments. The primary benefit of this program is that there are no fees associated with the consolidation, unlike private companies offering the same services while charging for their services.
Even though the federal government offers many useful resources, many Americans still find themselves forced to look to private companies for financial assistance. The reasons may include covering rent, groceries, and other living expenses while in school.
These private loans are provided by banks, credit unions, and other types of financial organizations, according to the Federal Deposit Insurance Corporation (FDIC). These types of loans require a credit check and possibly a co-signer for students who haven’t accrued much credit. Private loans provide fewer benefits to those borrowing from them than federal loans. The most significant talking points regarding private loans include:
- Fluctuating interest rates: Over the life of this type of loan, the interest the borrower must pay on the loan may increase. Because of this, the borrower may find themselves financially at risk if the rate rises. This fact also makes a repayment plan for private loans more difficult to put together.
- Less forgiving: Private loans have fewer options than federal loans when it comes to reducing or postponing payments. The ability to defer your private loans depends on your provider. Reach out to them or talk to them when applying for the loan to determine your options.
How Do Student Loans Affect Credit?
Both federal and private student loans will affect your credit score. How much you owe and whether or not you make your monthly payments on time can either raise or lower your credit score. On-time payment history will increase your score while missed payments will reduce it. Both federal and private loans have subtle differences regarding how they can affect your credit score outside of these basic rules.
- Hard credit inquiries: Subsidized and unsubsidized student loans do not result in a hard inquiry on your credit report. However, Direct PLUS loans do since they are based on credit health. Hard inquiries can temporarily lower a person’s credit score, which means certain federal loans can negatively affect your credit.
- Tax deduction: Student loan interest paid that exceeds $600 will result in the issuance of a 1098-E form used when filing your taxes. Anyone can claim a tax deduction of up to $2,500 yearly. If you paid less than $600, you might have to reach out to your lender to find out how much interest you paid over the year, but any interest paid up to the maximum yearly deduction is claimable.
- Fixed interest rates: Many of the federal loans offered have fixed interest rates. Federal law dictates what the interest rate will be on an annual basis. The interest rate is applied based on the disbursement date and loan type. While the interest rate remains set for the life of the loan, subsidized and unsubsidized federal loans have a lower interest rate than the Direct PLUS Loans.
- Historically lower interest rates: According to the Federal Student Aid website, federal interest rates are usually lower than private financial aid providers.
- Hard credit inquiries: Private loans are based primarily on your credit score, meaning they require a credit check when applying. When your credit gets checked, it creates a hard inquiry, which can lower your credit score temporarily.
- Tax deductions: Like their federal counterparts, private loan interest can be tax deducted up to $2,500 annually.
- Variable interest rates: While their federal equivalents offer fixed interest rates, based on federal law, private lenders may change their interest rates based on internal regulations. Sometimes, a better credit score can earn you a lower interest rate, but that isn’t always the case. The wide ranges of interest and its fluctuating nature make it hard to estimate how much you will actually repay for the loan.
- High interest rates: Within the topic of these fluctuating interest rates, private loans are also historically more likely to offer higher interest rates than federal loans, even though some federal loan interest rates can be higher than private loans.
Understanding the Options
With the majority of Americans attending college relying on student loans to pay for tuition, living expenses, and other associated costs, understanding the available options is essential. Our experts at Collegefinance.com are great resources for understanding the ins and outs of the student loan world, so you can worry less when the time comes to get your degree.
It’s widely accepted to rely on federal support before considering any private loans. Federal laws protect the borrower, so you can trust your repayment plan will be easier to accomplish. Additionally, you can rest assured of benefits like deferment of payment if you find yourself in a tight financial situation, fixed interest rates for clarity, and even potential forgiveness of the loan.
Student loans have the potential to drastically affect your credit score, whether they are federal or private student loans. Commit to on-time payments, try to keep your total amount borrowed as low as possible, and discuss your interest rates with your lenders. Both options may be necessary, and you can set yourself up for success by knowing how each option will affect your credit. Student loans don’t have to be scary as long as you do your homework.