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How Do Student Loans Work?

What you'll learn: The ins and outs of student loans


Student loans are amounts of money that you borrow to fund your higher education. You pay them back over time, usually with interest. You may currently have student loans if you are in college or trade school or if you have graduated within the past couple of decades. Student loans may be in your future if you are looking to advance in your current career path, or if you are thinking about switching to a profession that requires you to obtain higher education. In either case, it’s good to understand how student loans work to use them to your advantage and effectively manage them.

Applying for Student Loans

If you plan on borrowing money for school, you can apply for a student loan, and other sources of funding, when you apply for school. The form you use to apply for government loans is the Free Application for Federal Student Aid (FAFSA), which can also be found online. To estimate the amount of financial aid you may be eligible for, you can use the federal government’s FAFSA4caster

You can also apply for private student loans offered by credit unions, banks, and other organizations. Compare private loans and search for scholarships on websites like the public service site

If you are already enrolled and taking classes, take a look at information about applying for student loans in your next semester.

Accepting Federal Student Loans

When your financial aid offer comes back from the schools you’re applying to, look at the grants and scholarships that you’re offered. These generally don’t have to be repaid. The exception to this is any scholarships that requires “repayment” via work in a particular field and/or geographic area. Before deciding how much student loan money to accept, take advantage of grants and scholarships.

To start receiving a federal student loan, you will be asked to take part in entrance counseling to learn your rights and responsibilities as a borrower. You will then sign a promissory note, a legally binding document that lists the terms and conditions under which you will repay the loan. You will be given a copy of the signed promissory note, which you should keep in a secure place.

Federal Loan Facts and Repayment

The federal government provides different types of student loans, depending on the borrower’s situation, as well as several repayment options.

Direct Subsidized Loans

If you’re an undergraduate student with demonstrated financial need, you may be eligible for a subsidized federal loan. A demonstrated financial need can be determined by subtracting your expected contribution amount towards tuition from the full cost of attendance. The amount of the subsidized loan is capped at the level of your financial need. If you take out a subsidized loan, the federal government pays the interest while you’re in school and during any periods of eligible deferment.

Direct Unsubsidized Loans

Unsubsidized loans are available to any undergraduate or graduate student. The amount is determined by the cost of attendance at your school and any other aid you’re receiving. If you take out an unsubsidized loan, you are responsible for any interest that accrues while you’re in school and afterward, including during any deferment periods.

Direct PLUS Loans

If you are a graduate or professional student, or the parent of a dependent undergraduate student, you can apply for a direct PLUS loan from the U.S. Department of Education. They require a credit check and a decent credit history. The loan funds are intended to cover any expenses that other financial aid does not.

Direct Consolidation Loans

If you have multiple federal loans, you can combine them into a single loan from a single servicer called a direct consolidation loan.

Federal Student Loan Facts and Figures

  • You find current loan rates here. They are usually fixed rates.
  • For most loans, you don’t need a cosigner.
  • For loans other than PLUS loans, you don’t need a credit check.
  • The interest is tax-deductible.

Paying Back Federal Loans

In general, you don’t need to pay them back during school as long as you’re in school at least half-time. There is usually have a six-month grace period after graduation before you must start repayment, although you can pay them back early without prepayment penalties. You have several repayment options. Check out the federal government’s loan simulator to help you determine your best option.

Standard Repayment Plan

You make a fixed monthly payment to pay your loan off in 10 years, or 30 years for a direct consolidation loan. This option saves the most money overall but costs more per payment.

Graduated Repayment Plan

You start with smaller payments that increase every two years, to pay off the loan in 10 years. This option might be good for you if you think that your income-to-expenses ratio (excepting the loan) will generally increase in the long run.

Extended Repayment Plan

You make monthly payments on a fixed or graduated plan to pay the loan in 25 years. You are only eligible for this option if you have $33,000 or more in debt.

Income-Based Repayment Plan

Your monthly payments are capped at 10% of your discretionary income. Discretionary income is the difference between your income and 150% of the poverty guidelines for your state and family size.

Income-Contingent Repayment Plan

You make monthly payments equal to either 20% of your discretionary income or the amount you’d pay monthly with a fixed payment over 12 years, whichever is less.

Income-Sensitive Repayment Plan

You make monthly payments based on your annual income for up to 15 years.

Private Loan Facts and Repayment

While federal loans offer more flexibility than private loans, you may choose the latter for additional expenses not covered by federal loans, or if you make too much money to qualify for federal loans, but want more options for your current savings and income.

The lender — bank, credit union, school, organization — of a private loan decides your eligibility. The amount you can take out and the options for repayment are also up to the lender.

Private Student Loan Facts and Figures

  • Loan rates vary and are set by the lender.
  • Rates may be fixed or variable.
  • You may need a credit check and/or a cosigner to take out a private loan.
  • The interest is not always tax-deductible.

Paying Back Private Loans

  • Learn about repayment options and timelines before you sign for a loan.
  • Lenders may allow deferment or forbearance.
  • You may be able to renegotiate a high interest rate.
  • You usually have a six-month grace period after graduation before you must start repayment.

Getting Help — and Helping Yourself — With Student Loans

  • Consider a cosigner. If you have a limited credit history or income, having a credit-worthy cosigner might help you obtain a loan that requires a credit check. With a cosigner, you might increase your chance of getting approved for a loan and/or be eligible for a lower interest rate. 
  • Set money aside early. The sooner you start saving for your education, the less you will need to borrow or pay interest on. You have two options for money that you set aside. You can use it to make direct payments for school tuition, fees, and other expenses, or you can invest it wisely while you’re in school, and then use the principle plus earnings to pay off your student loan early, maybe even before your loan starts to accrue interest. If you opt for the latter route, you’ll want to consider your savings amount and perform some calculations to compare the amount much interest you will pay on a loan versus the expected growth of your savings.
  • Get help early if you are having problems paying your loan. If you find that you can no longer make your loan payments due to loss of income or unforeseen expenses, talk to your loan servicer as soon as possible so that you don’t fall behind. See if you can renegotiate a rate, switch to a different payment plan, defer your loans, or consolidate multiple loans into one.

Even after graduating, there are ways to save money and manage your loans with refinancing. Refinancing your student loans consolidates them into one loan and one payment. This new loan has a different interest rate, monthly repayment, and repayment term. Depending on your needs, refinancing your student loans can save you a significant amount of money.

Student loans can help to bridge gaps between your current financial situation and obtaining the education that can help you advance toward your career goals. Understanding how student loans work can help you effectively manage them.