Why Do Private Student Loans Have Such High Interest Rates?

Private student loans carry higher loan interest rates than federal student loans for several reasons. Private lenders are not subject to the same restrictions as those who participate in the federal student loan program with respect to the amount of money they lend and the terms for repayment of the debt.

Because of their ability to lend to anyone without regard to credit history or rating, a private student loan is free to base its rates on the prevailing market interest rates in order to price their student loans. The higher interest rates charged on private student loans account for the risk inherent with accepting all types of credit profiles.

The amount of interest that a private student loan charges in excess of what is charged on a federal student loan is a risk premium. The private loan’s risk premium is a hedge against defaults or loan failure associated with a certain class of borrowers.

Statutory Limits on Federal Student Loan Interest Rates

The federal government sets the loan rate for their loan programs. This limit or cap on interest means that the amount of interest charged in any given year is limited to that cap rate. This makes borrowing federal student loans more attractive for many borrowers looking to finance a student’s college education.

Loan Guarantees

The loans provided through the government, including PLUS and Stafford loans, are backed by the U.S. Department of Education and a state guaranty association. These loan guarantors are not available to private lenders. Loan guarantees provide a way for schools to protect their financial liability and offer these loans to many student borrowers and their parent.

Borrowing Limits

Federal student loans are subject to borrowing limits that are set in place to make available as many loans as there are requests. The Stafford loan for example has in place a limit of up to $5,500 in the student’s first year, $6,500 in the second and $7,500 in years 3 and 4. The loan caps are necessary to make the loans widely available and ensure that students and their parents exhaust all of their resources. These caps result in lower interest rates for borrowers since the government’s risk is lower.

If a private student loan instituted limits on the amount of money borrowed, had a secondary guarantor or capped their loan interest rates, you would see loans rates in line with the rates provided on federal loans. The fact that private student loans have such high interest rates is not as troublesome as they are essential in providing a way for some borrowers to obtain funding for school when certain federal student loan programs are not available.

 


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