How Do Student Loans Work?

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By Erica Gellerman

May 27, 2021

If you need money for college, you might be considering a student loan. But before you apply for one, it’s important to understand how they work.

What is a Student Loan?

If you don’t have the money to pay for college, a student loan will enable you to borrow money and pay it back at a later date, with interest.

College loans are different from a grant or scholarship. If you receive a grant or a scholarship you’re not borrowing that money. That is money that has been given to you as a gift and doesn’t need to be repaid.

What Types of Student Loans are Available?

There are two main types of lenders that offer student loans. The U.S. government offers federal student loans. Banks, credit unions, state loan agencies and other financial institutions offer private student loans.

Be careful, as some of the lenders that offer private student loans also service federal student loans on behalf of the U.S. government, so it is easy to get confused.

Federal loans

Federal student loans are loans that are made by the U.S. government. It’s a good idea to take out federal loans first because these loans are less expensive and usually come with more benefits than loans from private lenders.

The advantages of a federal loan over a private loan include:

  • Fixed and lower interest rates
  • The ability to borrow money without a cosigner
  • Repayment plans that start six months after you leave college or attend less than half time
  • Flexible repayment plans like income-driven repayment and extended repayment
  • There is also the possibility that some of your loans can be forgiven — that is you don’t have to repay them — if you work in certain professions, such as teaching and public service

There are four types of federal student loans for college:

Direct Subsidized Loan

Subsidized Stafford loans are available to undergraduate students with demonstrated financial need. While enrolled in college at least half-time and for six months after you graduate or drop below half-time enrollment, you won’t have to pay interest on the amount you borrowed. This can be a huge cost savings.

Direct Unsubsidized Loan

Unsubsidized Stafford loans are available to undergraduate and graduate students, regardless of financial need. Unlike subsidized loans, you will need to pay the interest that has accrued on your loan while you are in college, or the interest will be capitalized (added to the loan balance).

Federal Direct PLUS loan

Grad PLUS and Parent PLUS loans are available to graduate students and parents of dependent undergraduate students. PLUS loans aren’t subsidized, so interest will start accruing as soon as the loan is fully disbursed. Repayment can be deferred while the student is enrolled in college and for six months after graduation.

Federal Direct Consolidation loan

Consolidation loans allow you to combine multiple federal student loans into one loan, without losing the benefits of the federal loans. Consolidation can be used to streamline repayment or to switch loan servicers.

Private loans

Private student loans are loans that come from a private lender, usually a bank, a credit union, a state loan agency or a non-bank financial institution. They can come with fixed or variable interest rates and often require the student borrower to have a cosigner. Interest isn’t subsidized, so as soon as you borrow money the loan will begin accruing interest.

How Does Interest on a Student Loan Work?

Because you’re not just paying back the amount you borrow, you’re paying back interest as well, it’s important to understand how much that will add to the total amount you pay.

How much you pay in interest depends on a number of factors: whether your loan is subsidized or unsubsidized, the interest rate on your loan, the amount you borrow, and the loan term.

For example, you graduate with a $10,000 loan with a 5% interest rate and plan to pay it off over 10 years. You will pay $2,728 in interest over the 10 years that you repay the loan. Your monthly loan payment will include both payments to reduce the principal balance (the amount borrowed) and interest payments. The total amount repaid will be $12,728 including both principal and interest. 

Interest generally continues to accrue during forbearances and other periods of non-payment. So, if you take a break on repaying your loans or skip a loan payment, the total cost of the loan will increase, and not just because of late fees.

Loan payments are applied to the loan balance in a particular order. First, the payment is applied to late fees and collection charges. Second, the payment is applied to the interest that has accrued since the last payment. Finally, any remaining money is applied to the principal balance. So, if you pay more each month, you will make quicker progress in paying down the debt.

You can use a loan calculator to help you calculate exactly how much you’ll pay in interest.

How to Pay Less Interest

You can reduce the amount you pay in interest by making extra loan payments to pay it off sooner or by refinancing your student loan to a loan with a lower interest rate. However, refinancing federal student loans into a private loan means a loss in many benefits – income-driven repayment options, possible loan forgiveness or widespread forgiveness, generous deferment options, and a death and disability discharge.

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How Do You Apply For Student Loans?

The application process for federal student loans and private student loans is different. Remember, you should only apply for a private student loan once you have exhausted your federal student loan options. 

Federal student loan process

To apply for a federal student loan you’ll need to file the Free Application for Federal Student Aid (FAFSA). The information on the FAFSA will determine how much you’ll be able to borrow. Your college will send you a financial aid offer, which will include details on how to accept your loan. You will then need to sign a Master Promissory Note (MPN).

Private student loan process 

To apply for a private loan you don’t need to file a FAFSA. You’ll need to apply for a loan with an individual lender. The lender will check your credit score and will often require a creditworthy cosigner.

If you have decided a private loan is right for you, check out our list of the best private loans to compare lenders. 

See also: Complete Guide to Applying for Student Loans

How Much Can You Borrow?

Because you will have to pay back the money that you borrow with your student loans for college, only borrow what you really need. The amount that you can borrow depends on the type of loan. For federal loans, your college will determine the amount of money that you can borrow, but there are some limits:

  • Undergraduate Federal Direct Stafford Loans: The borrowing limits are from $5,500 to $7,500 per year for dependent students and $9,500 to $12,500 per year for independent students, depending on your year in school.
  • Graduate Federal Direct Stafford Loans: The borrowing limit is up to $20,500 per year for graduate and professional students and up to $40,500 per year for medical school students.
  • Private loans: The maximum amount you can borrow from a private lender varies. Most lenders don’t let you borrow more than your college’s cost of attendance minus other financial aid.

Direct loans are also subject to aggregate loan limits, meaning there’s a maximum on the total amount that you can have in outstanding loans.

The borrowing limit for Federal Direct PLUS loans is generally the remainder of the cost of college not covered by Federal Direct Stafford loans and any other financial aid.

When Do You Pay Back Your Loans?

Federal Direct Stafford loans require that you begin loan repayment six months after you graduate, leave school, or drop below half-time enrollment. Although Federal Direct PLUS loans previously entered repayment within 60 days of full disbursement, since 2008 borrowers have been able to defer repayment until six months after the student graduates or drops below half-time enrollment.

Private loan repayment depends on the terms set by the lender. You may find that your lender requires you to make loan payments while still in school, though there may be options to defer (postpone) making loan payments. Interest continues to accrue during an in-school deferment and grace period.

If you don’t have the money to pay for college, student loans are a great option to help you finance your education. But it’s important to understand how loans work so there aren’t any surprises when it’s time to begin loan repayment.

A good place to start:

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