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How Student Loans Work

Private and Alternative Loans

college student
Private loans are different from federal loans as they're not backed by the Department of Education. Kevin Dodge/Getty Images

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Banks have been in the commercial lending business a lot longer than the U.S. government. This is both good and bad for you, the borrower. Because it saves them money, private lenders may offer a quarter percentage point off the interest rates they charge when you sign up for automatic payments. (Note that federal student loan servicers may do this too.)

Banks also offer other perks. You might get a rate discount for submitting payments on time, can receive a kickback for referrals or even benefit from loyalty yourself, according to Student Loan Hero. When you refinance student loans with a private lender, you could also benefit from a cashback bonus in addition to a lower interest rate, according to Student Loan Planner. Although they are not required to do so, some lenders offer deferments, usually around six months following graduation (more on that on the next page).

But student loans from private banks also have their disadvantages. For starters, you may not be eligible for one. Like traditional loans from commercial banks, eligibility for private student loans, sometimes called alternative student loans, is based on your creditworthiness.

If you have bad credit, you may not get a bank to lend to you. If this is the case, you may still be able to get a loan if you can come up with a friend or relative who's willing to co-sign on the loan. Cosigning is common for private student loans since most teenagers don't have the credit history to get a loan of such size. Be aware, however, that the co-signer's credit is just as on the hook as yours when repayment comes due.

With private student loans, lenders today usually offer both fixed and variable interest rates. Variable rates are based on one of two indices, the LIBOR (the London Interbank Offered Rate, or the rate banks charge one another for loans) or the prime rate (the rate at which the most creditworthy people can borrow money). This rate will be added to an additional percentage margin, based on your creditworthiness. Since the LIBOR and the prime rates fluctuate, so too will the interest rates on your loan payments if you choose a variable rate.

Like federal student loans, the bank will disburse funds to your school. You can usually borrow up to the full cost of tuition and fees. Unlike some federal loans, banks may act blindly to any scholarship or grant money you have to pay for tuition. So you can borrow all of the money you need to attend, even if you don't require that much. Any amount left over will be disbursed to you by your school. Again, remember that borrowing money is the most expensive way to pay for an education, and private student loans are often the most expensive of their kind. Be wise with how much money you borrow.

On the next page, we'll look at how interest may or may not accrue, depending on whether your loan is subsidized.

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