How Do Student Loans Work?
Student loans are designed to provide funding for your education. There are loans available from both the federal government and from private lenders. Interest rates are also standardized on federal loans while they vary from lender to lender for private loans.
Borrowing for college is often necessary because tuition, room and board, and other fees are well out of reach of most families. This is no surprise as the average cost of college for the 2017-18 school year ranged from $25,290 to $50,900 depending on college type.
Although the expenses are astronomical, borrowing to earn a degree is often worth it because studies show graduates of a four-year college or university have a significant earning advantage over those who only obtain a high school diploma.
However, it’s important to understand the world of student loan borrowing as much as possible before diving into it. This guide can help you understand how student loans work so that you can make responsible borrowing choices and financial aid decisions.
In this guide:
- What Are Student Loans?
- How Do Federal Student Loans Work?
- How Do Private Student Loans Work?
- Federal Student Loans vs. Private Student Loans
- Understanding Student Loans is Essential to Successful Repayment
What Are Student Loans?
Student loans are loans issued by the federal government or private lenders that are specifically intended to provide funds for school.
Qualifying requirements for federal student loans differ from other types of financing because the government recognizes students usually don’t have income or a credit history when borrowing to fund their education. The rules for loan payments also differ. For example, unlike other types of loans, it’s almost impossible to discharge student loans in bankruptcy.
It’s important to understand how student loans work—and the difference between federal and private student loans—so you can make a fully informed choice about how to best fund your education.
How Do Federal Student Loans Work?
For most borrowers, federal student loans are the best deal to finance their education. Federal loans from the U.S. Department of Education offer standardized rates, fees, and terms set by the government.
Qualifying for federal loans can be easier than for private loans. Additionally, students can benefit from borrower protections including Public Service Loan Forgiveness, loan forbearance or deferment to pause payments in times of hardship, and income-driven repayment options to cap payments at a percentage of income.
To qualify for any federal student aid, students will need to complete the Free Application for Federal Student Aid (FAFSA). This can be completed online and will require details about personal and family income.
Some of the key things to know about federal loans include the following:
Federal loan programs offer the same interest rates to all borrowers, no matter their credit scores. Interest rates offered differ depending upon the academic year and the particular loan program, as well as whether the borrower is in undergraduate school or graduate school.
Generally, the lowest interest rates are available to undergraduate borrowers and higher rates are charged to graduate students and parents who borrow through the PLUS loan program to finance their child’s education.
The interest rates on federal loans are set by Congress and are subject to change for each subsequent academic year and aren’t variable interest rates as they often are with private loans.
Use our other guide to learn more about how student loan interest works.
The terms of federal loan programs are generally considered very favorable to borrowers. In addition to competitive interest rates, repayment on federal loans for students is deferred until after graduation or until the borrower drops below half-time enrollment.
The federal government also allows a student loan grace period of at least six months after graduation before repayment begins. This does not mean interest doesn’t accrue during this time—it does, except on subsidized Stafford loans. However, the student isn’t expected to start repayment. This grace period allows the borrower to look for a job and become more financially stable before making monthly payments.
The standard repayment term for federal loans is 10 years. However, many borrowers take advantage of programs that lengthen the repayment period to as long as 30 years.
Students also have options for income-driven repayment plans, which cap a borrower’s monthly payments and forgive the remaining loan balance after a certain amount of years of on-time payments. However, longer repayment terms reduce monthly payments, but increase total interest cost—and any forgiven loan balance may be taxable as income.
The government also offers hardship deferrals and forbearance for borrowers who, because of temporary financial difficulties, cannot make their monthly payments.
Types of Federal Student Loans
Direct Subsidized Loans
Subsidized loans are a type of Stafford Loan and are available only to undergrads pursuing higher education who have demonstrated financial need when completing their Free Application for Federal Student Aid. There are both annual and aggregate loan amount limits on Direct Subsidized Loans.
The major benefit of Direct Subsidized Loans is that the government will pay for interest while in school, as well as when student loan payments have been deferred following graduation. This means you aren’t accruing interest and your loan balance isn’t growing while you’re in school. Direct Subsidized Loans also offer low fixed interest rates and a low standard origination fee—and you can qualify regardless of credit or income.
Direct Unsubsidized Loans
Both undergrads and graduate or professional students can qualify for Direct Unsubsidized Loans. These loans also offer low fixed rates and low origination fees and borrowers can qualify no matter what their credit or income history is. However, unlike Subsidized Loans, these loans aren’t based on financial need, and the government will not subsidize interest.
There are annual and aggregate limits for Direct Unsubsidized Loans as well—although the limits are higher for grad students than undergrads.
These loans are different from Direct Subsidized or Unsubsidized Loans in important ways. While they offer standardized interest rates and origination fees, these are higher than Direct Loans, and it’s sometimes possible for people with good credit to get a more affordable private loan.
You also cannot qualify for PLUS Loans with adverse credit, and for parents, payments are not automatically deferred while students are in school. Typically, repayment begins within 60 days of the time the loan has been dispersed.
PLUS Loans are also not eligible for income-driven repayment plans unless the loan has been consolidated under an eligible Consolidation Loan.
While it’s generally a good idea to exhaust federal loans before private loans, look carefully into your options to compare PLUS Loans and private loans when deciding which is best for you.
Consolidation Loans can be obtained only after you’ve already borrowed for school. If you have multiple existing federal student loans, you can obtain a Direct Consolidation Loan by completing a simple application.
Consolidating your loans can make repayment easier since you have just one loan to pay. You can also become eligible for Income-Based Repayment, Public Service Loan Forgiveness, and other borrower benefits that may not be available on PLUS Loans by consolidating those loans.
However, consolidation doesn’t change your interest rate. Your new rate is a weighted average of the existing loans you were paying.
How Do Private Student Loans Work?
Private student loans typically should be taken out only to fill the gap that federal loans can’t cover. That’s because private student loans usually cost more due to higher interest rates, and they offer fewer protections for borrowers.
However, for a select few students or parents with excellent credit and demonstrable income, it’s possible to get private student loans at interest rates that beat those offered by the federal government.
Whether you take out private loans as gap fillers or because they offer a more competitive interest rate, it’s important to understand how they differ from federal loans in some key areas, including the following:
Unlike federal student loans, private student loans have a lot of variety in their interest rates. For starters, while all federal loans have fixed interest rates, private lenders offer variable rates as well.
>> Read More: Fixed interest rates vs. variable interest rates
This means rates can change over time, so payments can sometimes rise. When taking out a private loan, the interest rate depends upon the borrower’s creditworthiness, including their credit score. Well-qualified borrowers receive more competitive interest rates.
Unfortunately, no private student loans offer subsidized interest.
Not everyone is approved for private student loans, as lenders have specific requirements borrowers must meet and a credit check is needed. Most college students do not have the credit score and income requirements to get private student loans on their own. Students who can’t qualify independently may be able to get approved for a loan—or get a better rate—with a cosigner.
Loan terms also vary among private lenders. Some lenders offer deferment of payments while the borrower is still in school and even a grace period after graduation.
Others require a borrower to start making payments right away while still enrolled. And while a 10-year repayment plan is standard, private lenders offer a variety of repayment terms including those lasting five years, 15 years, or 20 years.
Private lenders don’t offer many of the repayment plans federal loans do. Features such as hardship deferrals and forbearance are sometimes available but are not common on private loans.
And while some lenders offer extended repayment plans up to 20 years or more when you apply for a loan, a borrower who takes out a loan with a shorter repayment period is often stuck with that term unless he’s able to refinance with a different lender.
Federal Student Loans vs. Private Student Loans
|Federal Student Loans||Private Student Loans|
|Interest Rate Amounts||Generally lower||Generally higher|
|Interest Types||All fixed||Fixed or variable|
|Maximum Loan Amounts||Generally lower||Generally higher|
|Eligibility Requirements||Most students eligible||Based on creditworthiness|
|Public Service Loan Forgiveness||Available||Not Available|
Most students should max out their federal student loans before obtaining private loans. That’s because federal loans offer:
- More flexible repayment options, including income-based plans and deferment or forbearance to pause payments
- Lower fixed interest rates (for most loans) and standard rates and fees for each loan category
- Fixed interest rates on all loans—so you don’t have to worry about payments rising
- Public Service Loan Forgiveness if you work in qualifying jobs
- Easier qualifying requirements, regardless of credit score or income
This doesn’t mean there’s no place for private loans. You can often borrow more money with private than federal loans and may need to take out a private loan to cover costs that exceed what you can pay with your federal loans. Just remember, don’t borrow more than you need to from any source.
Understanding Student Loans is Essential to Successful Repayment
Understanding how student loans work and your student loan options are essential to ensure you can fund your education in the best way possible.
While debt repayment after graduation can be difficult, borrowing to earn a degree can enhance your earning power and open up the door to new opportunities. Just be sure you’re a responsible borrower so you are successful in repayment and set yourself up for future financial success.
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Author: Christy Rakoczy
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