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Federal student loans vs. private loans

Chris Farrell Dec 28, 2010

Question: I graduated in May with around 60k in student loans split evenly between private and federal loans. I have the ability to pay off completely a few of these loans. My question is should I pay off the federal loans that are at a higher fixed interest rate (6%) or pay off the private loans that are variable, but currently at a lower rate(1-month LIBOR + margin = 4.5%). I had originally thought to pay back the entirety of the private loans, but am now thinking that if interest rates are going to stay low for some time it may be better to pay off those with the higher rates. Should I plan on the LIBOR rate to stay low for the next several years? Anthony, Indianapolis, IN

Answer: I don’t think the interest rate is the key issue in a situation like yours. It’s the terms of the loan that matters. By that metric alone, I would get rid of your private student loans.

Let’s say you lost your job, got seriously ill, or simply faced a period of time when money was tight. You have a number of options with your federal student loans. You can put them into forbearance or defer them. You can change the terms of the loans and lower the monthly tab (at the price of increasing the overall cost of the loan.)

You can get a more comprehensive overview of your federal student loan options at Finaid.org.

What’s more, even though the current rate is higher on your federal loans than your private loans it’s a fixed rate of interest. That’s a nice insurance policy against the rising rates over the next several years. It may not happen. Then again, rates could go up. The fixed rate protects you against the risk.

Private student loans are more like personal loans or even credit cards. The lenders don’t care if you fall into financial trouble. They want you to make loan payments on time at the stated amount. In essence, the loan terms are inflexible.

I have been on a campaign that these loans shouldn’t be labeled “student” loans. It suggests that they are similar to federal student loans and they aren’t. It’s nothing more than a personal loan with a misleading label.

Taken altogether, you have a much greater margin of financial safety with the federal student loans compared to the private student loans. No question about it.

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