Consider this: If you're a dependent first-year college student, the maximum amount of federal loans you can qualify for is $5,500 per year. But the average total cost of attendance at a four-year public school was $23,250 for the 2022-2023 academic year; federal loans would pay for less than 25% of the cost. How do you cover the gap if you've exhausted scholarships and grants and reached the limit for federal loans?

This scenario is why many borrowers turn to private student loans. But what are private student loans, and how do they differ from federal education debt? Understanding how private loans work will help you make informed choices as you consider your financing options.

What are private student loans?

It's a common question among college students: What is a private student loan? Private student loans are one of the main types of student loans available to borrowers to pay for college or graduate school; the other option — which is far more common — is federal student loans.

While the U.S. Department of Education is the lender behind federal student loans, private student loans are issued by banks, credit unions, nonprofit organizations and for-profit financial institutions.

Private student loans make up a small percentage of the total student loan market. But they can be useful tools when you need additional financing to complete your degree.

Types of student loans from private lenders

Loan options vary by lender, but private lenders usually offer three different types of student loans:

• Undergraduate private loans: Undergraduate loans are for students pursuing associate or bachelor's degrees at community colleges or four-year schools.

• Graduate private loans: Graduate private loans are for graduate school and doctoral programs, including medical school, master's of business administration (MBA) programs and law school.

• Parent loans: Parent loans allow other family members to borrow on behalf of the student. Unlike federal parent loans, private parent loans are often available to other relatives, such as grandparents or legal guardians, and they can be used to pay for both undergraduate and graduate programs. With private parent loans, the student has no legal obligation to repay the loan; it's solely in the parent or family member's name.

How private loans work

Once issued, private loans work similarly to federal loans. If you're approved for a loan, the lender typically sends the money directly to your college. Your school will apply it to your tuition bill and other required fees. If there is money left over, you'll receive the remainder to use for your other expenses, such as transportation or textbooks.

However, private student loans differ from federal loans in several ways:

Borrowing amounts

As mentioned earlier, some federal student loans have limits on how much you can borrow per year and over your lifetime. By contrast, private student lenders usually allow you to borrow up to the school-certified cost of attendance.

Eligibility

Unlike federal student loans, private loans are credit-based. The lender will check your credit and income to determine your eligibility for a loan and set your rates. The requirements vary by lender, but students usually need good to excellent credit — a FICO score between 670 and 850 — and at least $35,000 in income.

Few college students meet those criteria, so most students need a co-signer to qualify for a private student loan. According to a 2022 study from Enterval Analytics, approximately 91% of private undergraduate student loans are co-signed.

Rates

Federal student loans have fixed-interest rates, and borrowers qualify for the same rate regardless of their credit history.

That's not the case with private loans; your rate varies based on your credit and other factors. And your loan can have fixed or variable rates. If you have a variable-rate loan, the rate can change over the life of your loan.

In-school payments

Most lenders require borrowers to make some form of monthly payment while the student is in college. Depending on the lender, you may have the following payment options while you're in school:

• Immediate: If you are on an immediate payment plan, you make full interest and principal payments as soon as the loan is disbursed. Although this plan has the highest in-school monthly payment, it has the lowest overall loan cost. Lenders typically charge lower rates for borrowers that choose this plan.

• Interest-only: With interest-only payments, your monthly payments cover the interest that accrues. This option has a smaller payment than immediate repayment but a higher overall repayment cost.

• Fixed: Fixed repayment plans allow borrowers to make small payments, such as $25 per month. This option has a higher overall cost than immediate or interest-only repayment, but the in-school payments are more manageable, and you are reducing some of the interest that accrues.

• Deferred: If you opt for a deferred payment plan, you don't have to make any payments until after you graduate or leave school. However, this option has the highest overall repayment cost, and lenders usually charge borrowers on this plan a higher rate.

Repayment terms

When you apply for a private student loan, you have more control over the loan term than you do with federal loans. Depending on which lender you choose, you could have a loan term as short as five years or as long as 15 years.

A longer repayment term can be appealing because it gives you a more affordable monthly payment. But you'll usually pay a higher rate, and more interest will accrue over time.

If your goal is to minimize your overall repayment cost, choose the shortest term that gives you a monthly payment you can manage.

How to take out a private student loan

Private student loans don't have a centralized application like federal loans. Instead of filling out the Free Application for Federal Student Aid (FAFSA), you'll have to apply through the individual lender.

To take out a private student loan, follow these steps:

1. Gather information

Save time during the application process by gathering some information and documentation ahead of time. You will likely need the following:

• Your Social Security number

• A form of government-issued identification, such as a driver's license or passport

• Employment information

• Proof of income, such as a recent paystub or your tax return

• Details on your college, program and target graduation date

2. Find a co-signer

Since most private student loans are co-signed, you will likely need to find someone to act as a co-signer. A co-signer can be a parent, relative or friend that has good credit and meets the lender's income requirements.

The co-signer will have to fill out their own application and provide details about themselves and their income.

3. Shop around

Because rates and terms can vary by lender, it's a good idea to shop around with different companies before deciding on a lender. Many companies allow you to prequalify for a loan and view options with a soft credit check, which doesn't impact your credit.

4. Fill out a loan application

Once you find a loan that works for you, you (and your co-signer) can fill out the application. The lender will prompt you to enter information about yourself, your income and your school. You will also have to consent to a hard credit check, which can cause your score to drop by a few points.

Once you submit the application, the lender will review your information and determine if you qualify for a loan. The lender will also certify the loan amount with your college.

5. Review and sign the loan agreement

If the lender approves your application, it will send you a notification and a loan disclosure form. The final loan terms may be different than the prequalification offer, so make sure you review it carefully and understand what interest rate is applied, what fees there are and how much your payments will be.

If you are comfortable with the loan's terms, sign and return it to the lender. The lender will then work to disburse the loan to your school.

Financing your college education

Although private student loans typically have higher rates than federal loans and stricter eligibility requirements, they can be useful tools when you need additional financing for school. Private loans can supplement your other financial aid to cover the total cost of attendance of your program.

If you need to take out private student loans, be sure to get rate quotes from several lenders to find the best deal.