How Do Student Loans Work?

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Updated on October 6, 2022

According to the office of Federal Student Aid, over 45 million people have federal student loans, with an average balance of $35,134.48 per person. Many students graduate with more student loan debt than they’ll make in a year, making it difficult to pay off the balance.

Student loans are a great way to finance your education if you use them responsibly. When you’re taking out student loans, it’s important to keep your likely future salary in mind to avoid being overburdened by debt.

What is a student loan?

A student loan is a loan you take out to pay for the cost of higher education. You can use them to pay for many levels of education, from community college to graduate school. You’ll need to show that you have a financial need in order to qualify for some types of student loans.

Student loans aren’t free money. Unlike grants or scholarships, you need to repay student loans with interest. Most student loans can only be used to pay for tuition, fees, room and board, books, and other eligible school-related expenses.

Student loans fall into two main categories: federal student loans and private student loans.

  • Federal student loans are part of the Federal Direct Loan Program that’s backed by the federal government. They have fixed interest rates that are set by Congress.

  • Private student loans are also used to pay for college costs, but the loan comes from a private lender instead of the U.S. Department of Education. Most private lenders are banks, credit unions, or schools themselves. They may have variable interest rates and may require a cosigner.

Beyond the loan amount, some student loans also have origination fees. These are one-time fees that are deducted from the money you receive. Origination fees are usually equal to a few percent (1%-4.5%) of the loan amount.

Your repayment terms, or a description of how you’re expected to repay your loans, will vary depending on the type of loan you receive. Many borrowers choose to consolidate their loans to have a single monthly payment, often at a lower interest rate.

How much money can you borrow in student loans?

There’s no one answer to the question of how much you can get in student loans. The amount you can borrow varies according to your financial need, how far along you are in your program, and your dependency status.

(Your dependency status refers to whether you’re legally financially independent from your parents/guardians.)

Each type of loan has different lending limits. Here’s how much you can borrow under each one:

Direct Subsidized Loans:

  • $3,500 for first-year undergraduate students

  • $4,500 for second-year undergraduate students

  • $5,500 per year for undergraduate students in their third year and up

Direct Unsubsidized Loans:

  • Dependent Undergraduate Students: $5,500-$7,500 per year (cap includes subsidized loans), limited to $31,000 total

  • Independent Undergraduate Students: $9,500-$12,500 per year (cap includes subsidized loans), limited to $57,500 total

  • Graduate Students and Professional Students: $20,500 per year, limited to $138,500 total

Direct PLUS Loans: Up to the cost of attendance, minus any other types of financial aid you receive

There are no explicit limits on how much you can borrow through private loans, but most lenders won’t give you more than the cost of attendance. Loan amounts vary depending on your credit history, income, and whether or not you have a cosigner vouching for you.

How much you can borrow and how much you should borrow are two different things. In the past few decades, many people have amassed vast sums of student loans.

Borrowing too much can leave you unable to afford a house, save for retirement, or even drive you into student loan default.

Make sure you’re making smart decisions about student loan debt. A good rule of thumb is to cap your student loans at the average salary someone in your field makes when they’re out of school. For example, if you should make $50k per year after graduation, don’t borrow more than $50k.

How much does it cost to get a student loan? The cost to get a student loan varies depending on the type of loan you get and the loan’s interest rate. You may have to pay origination fees for federal loans, which could be a few hundred to a few thousand dollars.

When do you have to pay back student loans?

While you’re in school, your loans will be in deferment, which means you don’t need to make any payments. After you graduate or you’re no longer enrolled in college at least half-time, you’ll often receive a 6-month grace period. This grace period applies to:

  • Some private loans

  • Direct Subsidized Loans

  • Direct Unsubsidized Loans

For PLUS loans, as well as some private and Perkins loans, the grace period can be even shorter. After your grace period — or lack thereof — it’s time to start repaying the loan. Your repayment terms will specify when you have to start paying back your loans.

Federal student loans

These loans are often the best choice for students who qualify for them. Federal student loans typically have a lower interest rate than private loans, and they have more flexible repayment plans. These include income-based repayment plans.

On the other hand, some federal loans also have stricter qualification requirements. For example, you have to demonstrate financial need to qualify for Direct Subsidized Loans. Private loans don’t have these same restrictions.

Unlike many private loans, you don’t need a cosigner to get a federal student loan at a reasonable interest rate. You also don’t need to have a credit check to get a federal loan, so you’re still eligible for these loans without a cosigner if you have poor credit or no credit history.

There are a few downsides to federal student loans. It’s not easy to discharge student loan debt without a lawyer if you declare bankruptcy. The government can also garnish your wages and tax refunds when you fall behind on your federal student loan payments.

There are several types of federal student loans you might qualify for, depending on your financial needs. The government previously offered Perkins loans to students with high financial needs, but those loans have been replaced by direct subsidized loans.

The current loan types offered by the federal student loan program include:

  • Direct Subsidized Loans

  • Direct Unsubsidized Loans

  • Federal Direct PLUS loans

  • Federal Direct Consolidation loans

Here’s what you need to know about each option.

Direct Subsidized Loans

Direct Subsidized Loans are loans from the federal government that the government pays interest on while you have at least half-time enrollment (while you’re in deferment). Only students who can show they have financial need receive these loans.

Direct Unsubsidized Loans

Federal Direct Unsubsidized Loans are like subsidized loans, but the government does not pay the interest on your loan while you’re in deferment. You can choose to either pay the interest while you’re in school or roll the interest into the loan balance and pay after graduation.

Federal Direct PLUS loans

Federal Direct PLUS loans are for graduate and professional students, as well as parents of undergraduate students (Parent PLUS Loans). PLUS loans cover educational costs that aren’t covered by other types of financial aid and require a credit check.

Federal Direct Consolidation loans

Federal Direct Consolidation loans allow students with direct subsidized, unsubsidized, and/or PLUS loans to refinance and consolidate their loans into a larger loan. Consolidation loans usually have an extended repayment period relative to other direct loans (30 years vs. 10 years).

Private student loans

Private student loans work similarly to federal student loans, except you’re borrowing from a private company, usually a bank or credit union, instead of the federal government. You still have to use the money to pay for educational expenses.

There are some significant differences between private and federal loans. First, private student loans have a wider variety of interest rates. Your interest rate depends on your income and credit history. It can also be impacted by the income and credit history of your cosigner if you need one.

Most college students need a cosigner for private loans, particularly if they want to get a reasonable interest rate. Your cosigner is on the hook to make payments when you can’t pay; otherwise, it will destroy their credit.

Before cosigning on any loan, look over the loan terms carefully.

Private student loans used to include the Federal Family Education Loan Program (FFELP) plan, which provided government-backed Stafford loans, PLUS loans, and consolidation loans through private lenders. However, the FFELP program was discontinued in 2010.

Student Loan Interest Explained

Interest starts to accrue after disbursement for unsubsidized student loans and after deferment ends for subsidized loans. If you have unsubsidized loans, you’ll save money if you finish your degree faster.

You’ll see a lot of different interest rates listed for student loans, particularly for private loans. Direct federal loan rates are set by Congress, so everyone gets the same rate based on the type of loan they take.

From July 1, 2021— July 1, 2022, the current interest rates for direct federal loans are:

  • 3.73% for Direct Subsidized and Unsubsidized loans for undergraduates

  • 5.28% for Direct Unsubsidized loans for graduate and professional students

  • 6.28% for Direct PLUS loans

You’ll pay higher interest rates for most private loans compared to federal loans.

Private loans can have fixed or variable interest rates. Fixed rates stay the same for the term of your loan. Variable rates go up and down relative to a benchmark interest rate. Your overall interest rate depends on your credit score, with higher credit scores receiving better rates.

When benchmark rates are low, you get a good deal on your variable interest rate and pay very little for your student loans. If the economy suddenly becomes very volatile, rates can skyrocket, which leaves you on the hook for more money than you can afford.

Are student loans worth it?

Is it worth it to get a student loan? It’s worth it to get a student loan if you’re borrowing an amount you can easily afford to pay off on a starting salary at a reasonable interest rate.

Before taking out a student loan, it’s essential to think critically about your future employment prospects and how much you’ll pay to get your degree. You may be better off getting a degree from a less expensive school or starting at a community college and finishing at a state school.

For example, let’s say you take out the federal average of $35,000 in student loans at the current undergraduate rate of 3.73% (ignoring the COVID-19 temporary student loan relief). You agree to pay back your loans over the standard length of 10 years.

You’ll be paying $349.88 every month for those 10 years. At the end of your loan term, you will have paid $6,986.10 in interest for a total cost of $41,986.10. You’ll wind up paying even more with private loans at higher interest rates or federal loans for grad students.

Important note: In almost all cases, it’s better to get a student loan than to put your tuition on credit cards. The best decision comes down to your financial situation and the interest rates you’ll get for the loan vs. your credit card interest rate.

If you want to hear about experiences of other borrowers, Reddit can be a great resource.

How to apply for student loans

Applying for student loans is a relatively simple process. You’ll need to have your financial information. You will be asked for your parents’ financial information as well if you’re a financially dependent undergraduate.

Applying for a federal loan

To qualify for a federal student loan, you’ll need to fill out a FAFSA (Free Application for Federal Student Aid) form each school year. FAFSA forms are what college financial aid offices use to calculate how much you’ll be able to pay and determine your eligibility for student loans.

Your school will put together a financial aid package and send it to you. You can accept or decline any of the financial aid they offer, including student loans. Be sure to look over the rates for any loans and whether you’ll be required to make interest payments while in school.

If you agree to receive student loans, you’ll sign a promissory note with all of the terms of your loan, including the length of the loan, your interest rate, and any other repayment terms.

Applying for a private loan

Borrowers should apply for private loans directly through the lending institution. The application process is similar to what you would do to apply for other types of loans. You’ll also authorize the institution to run your credit report so they can get your credit score.

5 tips for responsible borrowing

It’s easy to get in over your head with student loans. Here are some tips to help you borrow responsibly:

  1. Talk to your school’s financial aid office to learn about all of your loan options to see if you’re eligible for lower-rate loans.

  2. Minimize the amount you borrow as much as you can. Consider working part-time, participating in a work-study program, or going to a less expensive school.

  3. Don’t borrow more in student loans than you will make in your first year working.

  4. Keep records of your loan terms and promissory notes and look them over before your deferment term ends.

  5. If you need private loans, shop around to find the best interest rate possible.

These tips can help you set yourself up for future success in quickly repaying your loans.

Student loan repayment options

After you finish school, your loans will move into repayment — though some private loans, direct subsidized, and direct unsubsidized loans give a 6-month grace period.

How does paying back student loans work? Paying back student loans works by making monthly payments for the term of your loan. Your student loan servicer will tell you how much to pay each month and the due date.

How many years does it take to pay back a student loan? It can take just a few years or up to 30 years to pay back a student loan. The length of repayment depends on the loan amount, your interest rate, and your repayment terms. Though the Standard Repayment Plan estimates borrowers will finish federal student loan payments in 10 years, most borrowers need twice that time.

Standard loan repayment plans are 10 years, but extended plans can last longer.

Federal loan repayment

The federal government will assign a student loan servicer to collect your student loan payments. You’ll make your monthly payments to the servicer, and the servicer will keep track of how much you owe.

If you have federal direct loans, you may be eligible for a federal consolidation loan. They generally have a lower interest rate than private consolidation loans, and they also offer income-dependent repayment plans.

In some instances, you may be eligible for forbearance, a time when you’re required to make reduced or no payments on your loans.

Forbearances for federal loans are available if you:

  • Participate in AmeriCorps.

  • Are in a medical or dental residency program.

  • Are activated while serving in the National Guard.

  • Qualify for the U.S. Department of Defense Student Loan Repayment Program.

  • Experience financial hardship or other circumstances (though you may or may not be granted a forbearance in these instances).

During forbearance, your loans will still accrue interest. You can apply for forbearance through your student loan servicer.

There are federal loan forgiveness programs available, but they can be challenging to qualify for.

Private loan repayment

Private loan repayment is very similar to federal loan repayment, but you will make payments to your lender. In many cases, your lender may bundle and sell your loan, and they will notify you if you need to make your payments to another company.

If you can make some but not all of your monthly student loan payment, you can look into refinancing or consolidating your loans. I like SoFiCommonBond, and LendKey for refinancing and consolidation options.

You may find a loan at a lower interest rate or for an extended term that can help you lower your monthly payments.

What happens if you can’t pay back student loans?

Falling behind on your student loan payments is never a good idea, but it does happen to good people. It’s best to contact your loan servicer about forbearance before you fall behind on payments instead of burying your head in the sand.

If you miss a payment, your account is considered delinquent. Delinquent accounts will be included on your credit report and can hurt your credit score. After several missed payments, you will enter default, an even more serious stage of unpaid student loan debt and penalties.

If you go into default, you may have to pay back your entire loan immediately, you can’t apply for deferment or forbearance, and your lender can sue you. If your loan is federal, the government can also garnish your paycheck or keep your tax refund to recoup the balance.

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