Public vs. Private Student Loans: Why the Differences Matter to You

Now that college acceptance season is well under way, the time has come to get focused on the next harrowing step on the road from high school to the dorm: Paying for it. As hard as it is to get into the college of your dreams, financing four (or more) years there can be even more difficult. And just as the college and major you choose can have a huge impact on the rest of your life, the way you choose to pay for your education can mean the difference between a manageable post-college debt and a crushing burden that will dominate your financial life for years after graduation.

For decades, college tuitions have been rising steeply. In fact, measured in constant dollars, they've more than doubled in the last 25 years. With the average cost of one year of education at a four-year college or university hovering around $22,000, the old ideal of students working their way through college is dead and buried. Instead, for all but the wealthiest families, going to college now means taking out loans. Today, about two-thirds of undergrads take out educational loans. And the debt involved is significant: The average new graduate from the class of 2011 owed more than $26,000.

There are two basic types of student loans: federal and private. Federal loans are made by the government, either directly to the borrower or through his or her college, while private loans are made by banks. Here are some of the major differences between the two:

Interest Rates

Federal loans usually have a fixed rate, which means that the student borrowing the money agrees to the interest rate on the loan, then pays that same interest rate until the loan is paid off. Right now, that interest rates on federal loans range from 3.4 percent for subsidized Stafford loans for low-income students, 5 percent for Perkins loans, 6.8 percent for unsubsidized Stafford loans, and 7.9 percent for PLUS loans. Right now, these rates are set by Congress, but President Obama's most recent budget proposal would tie them to the interest rate for 10-year Treasury notes.

Private loans generally charge a higher interest rate than federal ones. Worse, private loan interest rates are often variable, which means that they can fluctuate with the market. In other words, a loan that starts out charging 5 percent can -- and often does -- rise into double digits.

Accrued Interest

Another attractive aspect of subsidized Stafford loans is that they don't start accruing interest until the student graduates. With other federal loans, and all private loans, the interest starts building up as soon as the student cashes the check. To put it mildly, four years of accrued interest will definitely add a chunk to your loan debt.

However, federal loan interest can often be counted as a tax write-off, which can save you a fair bit of money down the road. Interest on private loans, on the other hand, generally does not qualify for a tax write-off.

Repayment

Another big difference between federal loans and private ones is the issue of repayment. With federal loans, students don't have to start making payments until after graduation. But on many private loans, repayment (either of the full loan, or just the interest) starts immediately -- and failing to keep up with your payments can take a brutal toll on your credit rating.

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There are several other factors that can make it harder to repay private loans. For example, if you're planning to pay your loan off early in order to avoid paying extra interest, you might need to think again: some private loans levy a prepayment penalty on borrowers who try to pay ahead.

'Til Death Do Us Part

The repayment saga can even continue after death. Federal student loans can be partially or entirely retired if you agree to a few years in the Peace Corps, Teach for America, or various other service-related programs. Students who are having a hard time making their payments may qualify for a variety of postponement, forbearance, or consolidation options. Finally, if a student dies or is disabled, part or all of his or her student loan debt may be retired.

Unfortunately, private loans are a lot tougher when it comes to repayment. Most private loans don't offer forbearance, flexible payment, or consolidation options. To make things worse, they also often require a cosigner, who is then responsible for the loan in the event that the student can't keep up his or her repayments. And, if a student dies while owing money on a private loan, the lender may go after the cosigner in an attempt to recover some of the missing money.

When You Should Go for a Private Loan

It's pretty clear that, generally speaking, it's rarely a good idea to get a private student loan. However, there are a few times when it makes sense. For example, if you have a guaranteed job waiting for you after you finish your program -- and if the job will pay enough money to service your debt -- getting a private loan might make sense. Similarly, if you don't actually need the money, but want to use the loan to help you manage your finances, then borrowing private money could be a wise choice.

For the most part, though, private loans aren't a good way to go. In fact, if the only way to pay for your degree is through private loans, you might want to seriously think about going to another school or enrolling in a less expensive program.

Bruce Watson is DailyFinance's Savings editor. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.

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