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How Do Student Loans Work?
By Jessica Walrack MONEY RESEARCH COLLECTIVE
How do student loans work and where can you find the best deal? In short, they help you pay for college in exchange for interest and fees. Your two main options are federal and private student loans, but there are some important differences between the two. Here, you’ll find student loans explained from A to Z in one easy place.
Table of contents
- Why take out student loans?
- Types of student loans available
- Student loans interest rates
- Student loan repayment options
- How to pay less interest on your student loans
Student loans provide students with the funds necessary to pay for higher education. They offer a lump sum of money that is disbursed to a borrower or to the school he or she attends. The student then repays the loan, plus interest and fees, over an agreed-upon term.
While taking out loans can be essential for many students, you may be wondering how you can get approved for a student loan when you don’t have much of a credit history yet. You might also be wondering whether federal or private student loans are better. We’ll answer those questions and more to help you understand exactly how student loans work and where you can find the best deal.
Why take out student loans?
Higher education can be expensive. During the 2019-2020 school year, the average cost for tuition and fees at a public, four-year college was $9,400. At a private four-year college, the average was almost four times that amount, sitting at $36,700. Keep in mind, that’s the cost per year and you attend for four years.
By the time you graduate with a bachelor’s degree, you’re looking at spending anywhere from $37,600 to $146,800, depending on the type of school you attend. That’s a huge expense, especially for young adults fresh out of high school. If a scholarship or college fund isn’t available, student loans are often the only way to cover the bill.
Types of student loans available
Where can you find student loans? You have two main options — federal student loans provided by the government or private student loans from private lenders. Here’s a closer look at both options and how they work.
Federal student loans
The William D. Ford Federal Direct Loan Program was created by the U.S. Department of Education (ED) to help Americans finance the costs of higher education. Currently, 43.4 million borrowers have federal student loan debt totaling over $1.611 trillion. Here’s a look at the four loan options in the Direct Loan Program.
Direct Subsidized Loans
Direct Subsidized Loans are designed to help undergraduate students who have a qualifying financial need to pay for the costs of higher education. That education can take place at a four-year college, community college, trade school, technical school, or career school.
A standout benefit of these loans is that the ED pays the interest on the loan while you’re enrolled in school at least half-time, during your six-month grace period, and during a period of deferment (if you have one).
As for the loan amount, your school will determine how much you can borrow, up to the limits set by the ED. The maximum limit over the course of your studies is $23,000 if you’re an undergraduate student, and $65,500 if you’re a graduate or professional student. Annual limits will also apply.
Direct Unsubsidized Loans
Direct Unsubsidized Loans help both undergraduate and graduate students pay for higher education at a four-year college, community college trade school, career school, or technical school. Unlike Direct Subsidized Loans, these loans don’t require borrowers to demonstrate a financial need. They also differ in that you’ll be responsible for paying all of the interest.
As for the loan amount, you can borrow up to the cost of your attendance (tuition, room and board, books, etc.) minus any financial aid you receive. Further, your loan amount also must fall under the following limits based on your tax filing status and study program:
- Dependent undergraduate students: $31,000
- Independent undergraduate students: $57,500
- Independent graduate or professional students: $138,500
Again, annual limits will also apply. Further, if you’re a dependent undergrad student and your parents aren’t able to obtain PLUS loans, the independent undergrad student loan limit will apply to you.
Direct PLUS Loans
Direct PLUS loans can help to pay for qualifying education costs that aren’t covered by other forms of financial aid. They’re available to graduate and professional students as well as to the parents of dependent undergraduate students.
When Direct PLUS loans are made to professional or graduate students, they’re commonly called Grad Plus Loans. On the other hand, when made to parents, they’re called Parent PLUS loans.
To get approved for either type of Direct PLUS loan, you can’t have a poor credit history. Further, the maximum amount you can get is equal to the cost of attendance, minus any other financial aid that’s been received. There are no set annual or aggregate limits.
Direct Consolidation Loans
If you have multiple federal student loans with different servicers, Direct Consolidation Loans let you combine them all into a single loan with one loan servicer. There’s no minimum or maximum limit on the amount you can consolidate and most federal loans are eligible, except for Parent PLUS loans. Consolidated loans feature fixed interest rates pegged to the weighted average of the interest rates on all the loans being consolidated, rounded up to the nearest one-eighth of 1%.
Taking this step can make your repayments more convenient and can potentially lower your monthly payment amount by extending your loan term. However, extending your loan term will up your overall costs. Additionally, the consolidation process can cause you to lose some benefits like interest rate discounts, loan cancellation benefits, protections, and principal rebates.
You’ll have to weigh the pros and cons to decide if it’s the best choice for you. If you decide it is, you can request the Direct Consolidation Loan once you graduate, leave school, or drop below half-time enrollment.
Private student loans
Private student loans are provided by privately-owned financial institutions such as banks, credit unions, and online lenders, and they currently account for 8.4% of the total outstanding amount of student loan debt.
Like federal student loans, they are unsecured term loans that provide a lump sum upfront which is repaid, plus interest and fees, over a set term. However, unlike federal loans, you’ll need a good credit score, an established credit history, and proof of income to qualify. When college students don’t have established income or credit yet, private student loans won’t be an option unless they have a creditworthy cosigner.
Federal student loans generally offer significant advantages over private student loans.
- Lower fixed interest rates.
- Don’t need a credit check or cosigner to get approved.
- Don’t have to start making payments right away.
- Perks like having your interest paid for you, lower origination fees, and flexible repayment plans.
To apply for federal loans, you’ll need to fill out the Free Application for Federal Student Aid (FAFSA) form which you can get online or at your school’s financial aid office. As for private loans, you’ll need to visit the websites of student loan lenders and complete the applications.
Student loan interest rates
The student loan interest rate you get will determine how much you spend over the life of the loan so it’s important to get the lowest rate possible. Even a small fraction of a percentage difference in your interest rate can mean paying thousands more over a 10- or 20-year term.
With federal student loans, the interest rates are fixed so they won’t change throughout the loan term. They are also set each year for the various loan and borrower types. For example, federal loans disbursed after July 1, 2021, and before July 1, 2022, have the following fixed interest rates:
- Direct Subsidized Loans and Direct Unsubsidized Loans: 3.73% for undergraduates
- Direct Unsubsidized Loans: 5.28% for graduate or professional students
- Direct PLUS Loans: 6.28% for parents, graduate students, or professional students
As for private student loans, the interest rates may be fixed or variable. Private lenders offer a range of rates and will assign you a specific rate after assessing your credit application. For example, Sallie Mae offers undergraduate students variable interest rates from 1.37% up to 11.48% APR and fixed interest rates from 3.50% to 12.60% APR.
While a select few well-qualified borrowers could potentially get a lower interest rate with a private lender, most will find that federal loans offer the lowest rates.
Student loans repayment options
When it comes time to repay your student loan, your repayment terms will become important. So how do they work with federal and private student loans? Here’s what you should know.
Federal student loan repayment plans
One of the big perks of federal loans is that they come with various repayment plan options that are very flexible. Several of these can help you avoid missed payments if you have trouble affording your loan at any point in your term.
Standard
Under the Standard Repayment Plan, borrowers make fixed payments over a period of 10 years (or up to 30 years for Consolidation Loans). All borrowers are eligible for this plan.
Graduated
The Graduated Repayment Plan also splits up your payments over 10 years. However, the payment amount starts lower and then increases over the loan term. All borrowers are also eligible for this plan.
Extended
The Extended Repayment Plan gives you more time to repay the loan. You can opt for fixed or graduated payments over a term of 25 years. Eligibility for this plan depends on your loan amount, and Direct Loan borrowers must owe over $30,000 in Direct Loans.
Revised Pay As You Earn (REPAYE)
The Revised Pay As You Earn Repayment Plan (REPAYE) is an income-driven repayment plan that makes your monthly payment amount equal to 10% of your discretionary income. Each year, your payment amount will be recalculated based on your income and family size.
If you haven’t repaid your loan amount in full after 20 years, and your loans were for undergraduate studies, the remaining amount will be forgiven. If your loans were for graduate or professional study, they will be forgiven after 25 years. All student Direct Loan borrowers will qualify for this plan.
Pay As You Earn (PAYE)
The Pay As You Earn (PAYE) Repayment Plan is another income-driven repayment option. It sets your monthly payment amount at 10% of your discretionary income but can’t be more than you’d pay with the Standard Repayment Plan. Each year, the payment amount will be updated based on your income. All student Direct Loan borrowers will qualify (as long as you became a new borrower after October 1st of 2007 and got your Direct Loan after October 1, 2011).
Income-Based (IBR)
Under an Income-Based Repayment Plan (IBR), your monthly payments are set at either 10% or 15% of your discretionary income but not more than the payments on a Standard Repayment Plan would be. Payment amounts are updated each year and the balance is forgiven after 20 or 25 years, depending on when you received your loans. To qualify, you need to have a high level of debt in comparison to your income and you must be a student Direct Loan borrower.
Income-Contingent (ICR)
Income-Contingent Repayment Plans (ICRs) set your monthly payment amount at 20% of your discretionary income or the amount you’d pay on a 12-year fixed repayment plan, whichever is less. All student Direct Loan borrowers will qualify.
Income-Sensitive
Income-Sensitive Repayment Plans base your monthly payment on your annual income but require the loan to be paid off within 15 years. This plan is only available for Federal Family Education Loans which aren’t eligible for Public Service Loan Forgiveness (PSLF).
Private student loan repayment plans
With private student loans, lenders typically split up your balance over a set number of monthly payments that span a specific term. If you run into a problem making your payments, it’s up to your lender whether you can modify your payment plan or not.
For example, one private student loan lender, Earnest, offers loan terms from five to 20 years. It doesn’t offer a grace period so your monthly payments of principal and interest will begin the month after disbursement. If you need to skip a payment, you can do so once per year after you’ve made at least six consecutive, on-time payments.
Earnest also offers a Rate Reduction Program for some delinquent borrowers that lowers your interest rate for six months to temporarily reduce your monthly payment amount. If a borrower can’t afford their higher payment amount permanently, Earnest may offer a Term and Rate Modification Program where the term is extended and the interest rate is permanently lowered.
This is just one example of a private lender offering alternative repayment options. Keep in mind that not all private lenders will be open to adjusting your payment plan, and those that are may only offer to do so under certain circumstances. As a result, federal loans often offer borrowers greater flexibility which can help to prevent default if you ever have trouble making your payments.
How to pay less interest on your student loans
The key to paying the least amount of interest on your student loan is finding the lowest fixed rate available to you from the get-go. Variable rates may start lower but often increase over time and end up costing more overall. In many cases, federal loans will offer the lowest rate but you don’t know for sure until you check around.
A good place to start is filling out the FAFSA to see what you qualify for. You can also shop around with a few private student loan lenders to get quotes. If you have a cosigner, make sure they apply with you.
From there, you can compare all your options to decide which loan will be the best fit. Remember, while a low interest rate is important, other factors impact your costs like the term length, fees, and loan forgiveness features. You’ll want to consider the whole picture to find the best student loan for your situation.
