Beware private student loans

NEW YORK -- Faced with last-minute college costs, it's tempting for families to turn to private student loans this time of year.

The danger is that borrowers may assume they come with the same terms as federal student loans. But the loans doled out by banks are far inferior; they're costlier and don't carry as many protections in case borrowers run into financial trouble.

If you're thinking about taking out a private student loan, here's what you should know.

How they work

Don't expect to waltz into a bank and borrow as much walking-around money as you like.

Private student loans are generally capped to your college's cost of attendance, minus any aid you already have. Lenders will ask your school to certify that the loan amount is in line with your needs.

The loan is then disbursed to the financial aid office, which will likely dispense money to you once a semester.

Depending on how the loan is set up, a school may apply the loan to tuition or other bills for you.

You'll also need a co-signer unless you can prove you have the means to repay the loan. The better the cosigner's credit score, the better the interest rate you'll get.

Remember that you can no longer get federal loans through private lenders. A new law this year consolidated the government's program and cut private lenders out of the process.

Federal loans are now disbursed only through college financial aid offices.

Interest rates

A big drawback with private student loans is that you can't lock in an interest rate. Instead, you get a variable rate that rises and falls with the movement of a certain benchmark, such as the prime rate charged by banks.

Since these benchmarks are at historic lows, any rate you're offered today by a bank is likely to climb. The average rate on private loans is currently between 8 percent and 8.5 percent, according to Student Lending Analytics.

By contrast, interest rates on most federal loans are fixed at 6.8 percent. And subsidized federal loans for the neediest students come with a fixed rate of 4.5 percent.

If you're still considering a private loan, check if the state where your school is located runs a private lending program.

The programs vary, but about a dozen states let borrowers lock in an interest rates on private loans. For details on these state programs, check out Student Lending Analytics at http://tinyurl.com/372lm83.

Protections

Federal student loans come equipped with many safety nets for borrowers. If graduates can't find work or barely earn enough to get by, for example, they can opt to defer payments.

The loans remain in good standing during this period, although interest continues to accrue. The guidelines of when borrowers can qualify for deferment are fairly clear-cut with federal loans.

With private loans, however, it's up to the lender to decide whether to grant relief. It's usually decided on a case-by-case basis, and the period of relief is generally much shorter than with federal loans.

Another important safety net for federal loans: Borrowers who earn modest salaries after graduation can apply to have payments capped at 15 percent of their discretionary income. For loans disbursed starting in 2014, payments will be capped at 10 percent of income.

The program also forgives any remaining debt after 25 years. Those in public service have loans forgiven after just 10 years.

Shop around

A common mistake is accepting the first private loan you're approved for, said Tim Ranzetta, founder of Student Lending Analytics. Borrowers also tend to just apply wherever they already have a checking account.

But it's worth scouting out a few places, since an online application usually takes about 15 minutes or so. In a recent test, Ranzetta was offered rates ranging from 6 percent at a federal credit union to 12.25 percent at Sallie Mae.

The student lender has since lowered its highest rate to 11.25 percent.

Once you settle on an offer, you also want to set up repayment to start as soon as possible.

You generally don't have to start paying off debt until after you graduate. But it's to your advantage to start repayment sooner if you can afford to.

In fact, Sallie Mae last year started requiring students to make interest payments while they're in school. An alternative introduced this year lets students pay just $25 a month.

It seems like a burden, but those in-school payments can greatly reduce the cost of your loan.

That's because you're limiting the impact of compound interest, or the interest on interest charges that pile up while you're in school.

And if you come into any extra money, remember there's no penalty for paying off loans faster than scheduled.