Student loans and the various repayment options can seem so complex you might think you’ll need a college degree just to understand it all.
Like most things, if you break it down into smaller parts, it’s easier to take it all in. Here’s a simple guide to how do student loans work.
What is a student loan?
A student loan is a special type of loan specifically for paying college tuition and related expenses, like living expenses or supplies.
Many college students don’t have enough money to pay for college and a student loan provides a way to earn a degree so they can pursue a career and put their knowledge to work.
Who can qualify for a student loan?
The qualification requirements for student loans can vary depending on where you plan to borrow and the type of loan you choose.
It may seem obvious, but you need to be a student to get a student loan. Specifically, most loans require that you’re enrolled at least half-time at a qualifying school.
Taking a few courses in your spare time typically isn’t enough to qualify for most loans. It’s also worth noting that most student loans are for 4-year schools.
If you need assistance for a 2-year community college or a trade school, you may have to investigate additional options. Some lenders do offer loans for 2-year programs, but there are fewer from which to choose.
In most states, you’ll also have to be 18 years of age for a private student loan, which makes you no longer a minor and eligible to enter into contracts. In some states, however, the age of majority is older.
For instance, in a handful of states, the age of majority is 21 years of age. You’ll also need a high school diploma, GED, or equivalent, and usually must be a US citizen or permanent resident.
Credit history, income and debt-to-income ratio
Depending on the type of loan you choose, other factors can affect your eligibility as well. For private student loan lenders, expect your credit history, your income, and your debt-to-income ratio to be considerations.
Applicants with higher credit scores may receive more favorable rates than those with lower scores.
Those with troubled credit scores may not qualify for a private loan at all. However, it’s extremely common for student loans to be approved through the use of a co-signer.
About 9 out of 10 private lender student loans for undergraduate (4-year) schools requires a cosigner. The reason is simple. Most young adults don’t have much credit history and may not have much income yet.
For most federal student loans, your credit history isn’t a consideration, nor are income or debt-to-income ratios. Instead, the process to get a federal student loan begins with a Free Application for Federal Student Aid (FAFSA).
However, for Federal PLUS loans, a good credit history is needed. Additional requirements for federal student loans also apply:
- US citizen, permanent resident, or eligible non-citizen
- Selective Service registration for male students
- Maintaining satisfactory academic progress (minimum 2.0 GPA/4.0 scale)
- Borrower must not be in default on a federal education loan
How do federal student loans work?
Most student loans are federal student loans (as opposed to private loans) — and the reasons are understandable. The average interest rate for undergraduate federal student loans is under 4.5% compared to nearly 8% for private student loans for undergraduates.
Your credit typically isn’t a consideration with federal student loans and repayment plans and interest rates are fixed, unlike private loans, which are often variable.
The process for getting a federal student loan begins with a Free Application for Federal Student Aid (FAFSA). The FAFSA application is available online and is also available as a mobile app for iOS and Android.
However, if you’re not quite ready to apply, FAFSA4caster is a useful tool you can use to understand your options and begin planning without actually applying for aid or a loan.
Be aware that FAFSA4caster uses estimates for some calculations, but within minutes you can have a better understanding of the amount of federal student aid that may be available.
When completing the actual FAFSA application, you can check the status of your application online. Within a few days of submitting your application, you’ll get your Student Aid Report (SAR), which summarizes the information you’ve submitted.
The award letter
Once you’re accepted to an approved school, you’ll receive an award letter from the school’s financial aid office that explains the aid offered to you by that school.
If you were accepted by more than one school, you’ll want to compare the award letters from all the schools to help choose the best value based on the aid offered, which may include partial scholarships from the schools themselves.
If your aid offer includes a federal loan, there are a few more steps to the process, including entrance counseling, which explains the loan obligations, and you’ll need to sign the Master Promissory Note (MPN), which is your promise to repay the loan, interest, and fees to the US Department of Education.
Interest rates for federal student loans are set annually according to the 10-year treasury note rate, but adjustments are made according to the loan type: subsidized Stafford, unsubsidized Stafford, or PLUS.
Once a loan is approved, rates for existing loans don’t change and new rates only apply to new applicants. Rates for undergraduate federal student loans in recent years have ranged from about 4.5% to 5%.
Rates for graduate students trend higher, with rates in recent years ranging from 6% to over 7.5%. Federal student loans may be subsidized or unsubsidized.
Subsidized loans are based on financial need and the school determines the amount you can borrow. The subsidy refers to interest on the loan.
- while you’re in school at least half-time,
- for the first six months after you leave school (referred to as a grace period*), and
- during a period of deferment (a postponement of loan payments).
Of note, subsidized loans are available for undergraduates and based on financial need. Graduate students or those unable to demonstrate a financial need may qualify for unsubsidized loans, which don’t offer the same paid-interest advantages.
An origination fee ranging from about 1% up to about 4% may apply for federal student loans and is deducted proportionately from each loan disbursement. These fees are used to compensate the loan servicer.
How do private student loans work?
Federal student loans are much more common, but there may be cases where a private student loan is more advantageous, like if the interest rate is lower, for example.
In most cases, private student loans require a cosigner because loan approval relies heavily on credit scores, income, and debt-to-income ratios.
Many students, especially recent high-school graduates don’t have established credit yet, so it’s common for parents or someone else with established credit to cosign the loan.
The Free Application for Federal Student Aid (FAFSA), which is the first step in applying for a federal student loan isn’t required at all for a private student loan.
When someone cosigns a loan, they become legally obligated to pay the debt. If the borrower can’t (or won’t) pay the loan, the cosigner assumes the burden of repayment.
It’s important to consider all your options before asking someone to cosign a student loan or any other type of loan because a missed payment or a default can affect the cosigner financially, and the credit damage can take years to undo in some cases.
Examine the structure of the loan carefully as it pertains to the cosigner. Many private student loans allow a cosigner to be released from any obligation after 24 consecutive on-time payments have been made. Other loans may not release the cosigner at all.
You may also find more flexibility in the amount of credit hours you need, with some private loans allowing any number of credit hours. By comparison, federal loans require at least half-time attendance.
There may also be some additional flexibility in how private student loan funds can be used when compared to federal student loans. There can be a few advantages in choosing a private student loan. Higher borrowing limits may be available.
Borrowing limits for federal student loans can have annual caps as well as aggregate limits. In cases where a federal loan isn’t enough to cover the cost of schooling, a private loan may be able to fill the gap.
Interest rates may also be lower than with a federal student loan, although the opposite is often true; be sure to compare rates for your unique situation. When interest rates are low in general, don’t expect much difference in the rates between federal and private student loans.
Currently, a borrower with a great credit score might save about 0.5% to 1% by choosing a private loan, assuming they qualify for the best rates. Rates for private student loans can be either variable or fixed.
Variable rate loans may be cheaper in the short term, but if interest rates rise, they could prove to be a costlier option. Fixed rates provide a predictable loan payment, but may have a slightly higher rate.
Banks and credit unions
Banks or credit unions are among the most common sources for private student loans. It’s also common for the award letter from your school to contain some offers for private student loans. Be sure to check online as well.
A number of lenders that you won’t find on the main street in your local town have competitive offers for private student loans. Some private student loans are available without an origination fee, so be sure to shop around and compare the total cost of each loan offer.
How much can you borrow?
Federal loans are subject to annual borrowing limits, whereas borrowing limits for private loans are based on income and credit qualifications — in addition to the actual cost of school-related expenses.
Federal loan limits are often the reason students seek private loans to bridge the gap. For example, current federal student loan borrowing limits for dependent students are as follows:
- First-Year Undergraduate Annual Loan Limit: $5,500. No more than $3,500 of this amount may be in subsidized loans.
- Second-Year Undergraduate Annual Loan Limit: $6,500. No more than $4,500 of this amount may be in subsidized loans.
- Third-Year and Beyond Undergraduate Annual Loan Limit: $7,500. No more than $5,500 of this amount may be in subsidized loans.
If no one can claim you as a dependent for tax purposes, the borrowing limits are higher. However, when comparing the limits above to the average costs of college, you’ll find a large gap in most cases.
In 2018, the average annual cost of tuition, fees, and room and board for private schools was over $48,000. For public schools, the price tag is more than halved, bringing costs down to just over $21,000, which is still much more than the federal annual loan limit for dependent undergraduates.
Reduce the cost of college
A lower borrowing limit isn’t necessarily a bad thing, however. Less debt is almost always a safer route and there may be several other ways to reduce college costs.
Depending on the school, your state, your grades, and other criteria, there may be several additional ways to reduce the cost of college through scholarships, grants, and work-study programs.
Several organizations offer an online “common scholarship” application, which allows you to apply for many scholarships at once.
However, it’s important to do your due diligence because wherever people are looking to save money, you can be certain some other people may be looking to take advantage of the situation either through charging fees or through outright scams.
Common scholarship applications may also miss some opportunities where the scholarship provider chooses not to participate in a common application.
Grants are another common way to get money for college expenses. As part of the FAFSA application, you can also check availability of certain grants, like Pell grants or SMART grants.
Unlike a loan, grants never have to be paid back and can reduce the need to borrow money for college.
Work-study programs are another popular way to help pay for college expenses. Many schools participate in the federal work-study program and eligibility for the program is based on financial need.
Hours are limited to ensure ample class time and available jobs tend to focus on civic education or work related to your field of study. It’s easy to underestimate the long-term costs of student loans.
Nationally, student debt is now nearing $1.6 trillion, more than auto loans, or credit cards. Debt of any type can be difficult to escape, but student loan debt is particularly concerning because it can be difficult to discharge the debt in a bankruptcy.
While not impossible, the percentage of bankruptcy filers who successfully discharge student loan debt is quite low because it depends upon proving undue hardship.
Reducing the amount you need to borrow through scholarships, grants, work-study programs, or other types of employment can reduce the financial risk student loans can bring after graduation.
What types of student loans are available?
Depending on your financial need, several types of student loans may be available to you.
- Subsidized Federal Direct Stafford Loans: Often simply referred to as Subsidized Student Loans or Subsidized Direct Loans, Subsidized Stafford Loans offer a unique benefit in that the interest is paid by the US Department of Education while you’re still in school, during a post-graduation grace period, and during loan deferment periods. Qualification for subsidized loans is based on financial need.
- Unsubsidized Federal Direct Stafford Loans: If you don’t qualify for a subsidized loan, you may be eligible for an Unsubsidized Federal Student loan. In this case, the government won’t pay your interest for you, but interest rates are fixed (as they also are with subsidized loans) and eligibility isn’t based on your credit score. Be aware that interest accrues on unsubsidized loans even when you aren’t required to make payments, causing the loan balance to grow.
- Federal Direct PLUS loans: Available to graduate students or parents of college students, PLUS loans have higher borrowing limits than direct loans — but also come with higher interest rates. Credit scores and other financial criteria may be used to determine eligibility, which differs from direct loans in which nearly anyone who meets basic eligibility can get approved. Repayment for PLUS loans begins 60 days after the funds are disbursed.
- Federal Direct Consolidation Loans: Some students find themselves with more than one federal student loan. It may make sense to consolidate these loans to reach a more manageable monthly payment. Federal Direct Consolidation Loans can be used to consolidate several types of federal education loans but cannot be used to consolidate private student loans.
- Private Loans: Private student loans can be used as primary loans, supplementary loans to fill the funding gap left by federal student loan lending limits, or to refinance student loan debt.
How does student loan interest work?
The effects of interest are one of the biggest challenges for student borrowers. As with most other types of loans, when you make a payment for a student loan, the payment is first applied to the interest (and any outstanding fees) and then the remainder is applied to the balance.
In many cases, this means the balance may go down very slowly. Because many loans have deferred payments while you’re still in school, the balance may even be growing larger.
Cumulatively, student loans total nearly $1.6 trillion, but recent graduates have about $30,000 in debt. Federal unsubsidized loans for tax dependents have an aggregate limit of $31,000 for undergraduates.
We can use the second figure to illustrate how the interest can affect the loan over time since many borrowers are likely to fit this profile. The current rate for direct unsubsidized loans is 4.53%. The standard repayment term for federal loans is 10 years.
Using simple math, a $31,000 loan at 4.53% interest over 10 years gives a monthly payment of $322 and a total of $7,607 in interest paid. Unfortunately for many graduates, the math isn’t quite that simple.
Capitalized interest refers to interest that accrues while you are in school and that is added to the loan principal at the end of each year — if it isn’t paid. You have the option of paying interest as you go to prevent the loan balance from growing.
The cost of this unpaid interest varies depending on the amount disbursed but if the interest isn’t paid, it gets added to the balance at the end of each year and now a larger balance is subject to interest.
Compound interest is great when investing, but it has the same snowball effect when applied to loan — and can become expensive over time.
The $31,000 borrowed over a 4-year undergraduate program in the example could blossom into thousands more if interest payments aren’t made during that time. Remember, the unpaid interest added to the loan balance can cost additional interest as time goes on.
Example of capitalized interest
To look at a simple example of capitalized interest, let’s assume your loan disbursed $5,000 in the first year. At a 4.53% rate, the interest cost over the first year is $226.50. If you don’t pay that amount, it’s added to the balance, making the new balance $5,226.50.
After 4 years, a $5,000 disbursement results in a balance of nearly $6,000 — all of which is now subject to interest — and that’s only for the first year’s disbursement. If possible, paying the interest as you go can save significant amounts of money later.
How does paying back student loans work?
Your repayment options vary based on the type of loan you choose or on the term you choose. The default term for federal loans is 10 years. However, longer terms may be available depending on the loan amount.
For loan amounts between $20,000 and $39,999, which covers the average student loan range, the maximum term is 20 years. A graduated plan is also available in which you only pay interest for the first few years of the loan, which keeps payments lower as you build your income.
Private loan terms can range from 5 years to 20 years. Typically, you’ll have a 6-month grace period following graduation before you have to start making payments.
For federal loans, you may have the opportunity to structure your loan payments in other ways, including Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE), Income-Based Repayment, or Income Contingent Repayment.
Each of these options has its advantages and disadvantages as well as requirements for eligibility. In particular, be aware of repayment plans in which the required payment is less than the interest amount. In general, expect alternative payment plans to cost more in interest over time if the repayment term is extended.
What happens if you never pay your student loans?
Past due student loans go through various stages over time. The first step, which happens after a 28-day grace period, is when your loan becomes delinquent. Serious delinquency occurs when a loan is 90 days past due.
Over 10% of the total student loan debt for the US currently falls into this category. At 270 days past due, the loan is considered to be in default. When the loan goes into default, the entire loan balance and any accrued interest immediately becomes due and payable.
Additionally, the credit bureaus are notified of the default, which can affect your credit score for several years. Legal action and wage garnishments are also possible.
Liens can be placed against property and tax refunds may be applied to the balance. In general, defaulting on a student loan has unpleasant ramifications.
If needed, consider an alternative payment plan for federal loans — or if you have a private loan, contact your lender to discuss your options.
How long before a student loan is written off?
If a student loan goes into default after 270 days, expect the lender (or the government) to pursue the balance indefinitely. You may be able to negotiate a settlement with the lender or the debt collector if the lender sells the debt.
However, there are legal ways for student loans to disappear. If you’re on a qualifying repayment plan for a federal student loan, you may also be eligible for loan forgiveness after a certain amount of time.
It’s important to become familiar with the pros and cons of each plan, but here is the length of time before you may be eligible for forgiveness for each payment plan option or program:
- Income Based Repayment Plan (IBR): 20 years
- Pay As You Earn Repayment Plan (PAYE): 20 years
- Revised Pay As You Earn Repayment Plan (RePAYE): 20 years
- Income Contingent Repayment Plan (ICR): 25 years
- Public Service Loan Forgiveness (PSLF): 10 years
At least two caveats exists, however. The Public Service Loan Forgiveness (PSLF) is one example of a student loan forgiveness program with so many hurdles that 99% of the people who applied for debt forgiveness have been denied.
Expect some challenging fine print. Additionally, forgiven debt — and bad debt that is written off — is subject to income tax. In effect, the government treats the forgiven amount as income and you’ll have to pay taxes on it, possibly in a higher tax bracket.
Know how do students loans work to reduce the amount you’ll need to borrow
Millions of young adults are struggling with student debt. While free college isn’t here just yet, there are still ways to reduce the amount you need for college and the amount you’ll need to borrow.
As a first goal, look for ways to reduce the balance you’ll have at graduation by pursuing scholarships and grants, or by working to pay part of your expenses. Also, be wary of interest that may be accruing in the background.
If you’re able to pay the interest costs while you’re in school, the result could be thousands of dollars saved in later years. Consider the school carefully as well. In some cases, it makes sense to invest in a more expensive school.
In other cases, a state school close to home is a wiser choice and can significantly reduce your overall college costs.