How Do Student Loans Really Work?

how do student loans work

Instead of spending four years dreading the unknown of student loans, spend a few minutes getting to know them instead. As with anything, the more you know, the less scary it is and the better prepared you’ll be. How do student loans work? Find out now.

How are student loans funded?

As of 2016, college students are graduating with an average of more than $37,000 in student loan debt. Overall, student loan debt is carried by more than 43 million borrowers, totaling nearly $1.3 trillion. Where, exactly, is all this money coming from? Well, it depends.

Federal student loans are funded by the US Department of Education. Federal student loan borrowers may be eligible for:

  1. Direct Subsidized Loans, available to undergraduates who demonstrate financial need.
  2. Direct Unsubsidized Loans, available to undergraduates, graduates, and professional students, and requiring no demonstration of financial need.
  3. Direct PLUS Loans, available to graduates, professional students, and parents of dependent undergraduates.
  4. Direct Consolidation Loans, available to borrowers who want to combine multiple federal loans into one.

Perkins Loans are also part of a federal program, but they are funded by the schools and available to graduates and undergraduates who demonstrate exceptional financial need.

Private student loans are nonfederal loans funded by private lenders (for example, banks, credit unions, and other lenders).

How do you get student loans?

The first step is filling out the FAFSA (Free Application for Federal Student Aid). Hoping you won’t need student loans? That’s all the more reason to fill it out. The FAFSA is the key to all things college funding, including scholarships, Pell Grants, and work-study programs that provide financial assistance that you don’t pay back.

After reviewing your FAFSA, your school will send you a financial aid award letter with a breakdown of their offer, including any federal student loans for which you qualify.

They may also include a list of private student loan lenders they recommend. This requires a direct application to the bank, credit union, or other lender. Qualifying will likely depend on your credit history and may require a cosigner.

(Neither of these things is necessary to receive a federal student loan, with the exception of PLUS loans, which do rely on credit.)

Interest rates

All student loans come with interest rates, which is the fee your lender charges you to borrow your loan money. Interest rates are a percentage of how much you owe, and they are almost always higher on private loans than federal.

How do federal student loans work?

If you have federal student loans, the interest rate is always fixed, meaning it will never change. Federal interest rates vary only by loan type.

How do private student loans work?

As for private loans, interest rates can be fixed or variable. The interest type (fixed or variable) and interest rate depends on the lender, your credit rating, and other qualifying factors.

Be especially leery of variable interest rates, as they can go up at any time. Some come with a cap, but not all of them do — some variable interest rates can climb to more than 18 percent.

How do student loans work while you’re in school?

If you have a subsidized student loan, the federal government will pay the interest on your loan while you are enrolled in school (at least half-time), as well as during the grace period after graduation.

For all other federal loans, the government does not pay your interest while you are in school. Instead, interest accrues during this time and gets added to the principal balance at the end of your grace period.

When that happens, you are then paying interest on interest. The good news is you can prevent this from happening by making payments on the interest before the grace period ends.

As for private student loans, interest not only accrues while you are in school, but you may also be required to make payments before you graduate (something that’s never required of you for federal student loans).

How do student loan payments work?

Payment plans

For federal student loans, the standard payment plan is 10 years. It’s best to stick with this standard if you can, as you will pay your loan off faster (especially if you send in extra payments). But if you’re struggling to make the monthly payment, you may consider an income-driven repayment plan.

While an income-driven repayment plan will lower your monthly payment, it will also lengthen your loan and probably end up costing you more in interest over the life of your loan. But this is always the better alternative to missing payments.

You don’t have the same flexibility with private student loans, as they don’t come with the same guaranteed income-driven repayment plans.

Student loan servicers

These are the companies that act as the middleman between you and your lender. It’s your servicer to whom you send your money and contact if you are having any sort of problem with your loan.

Automating payments

You can have your federal loan servicer automatically deduct your loan payment each month from your bank account. You will never miss a payment, and you will also qualify for a .25 percent interest rate reduction when you sign up for direct debit through your servicer.

Amortization

When you have an installment loan (like a student loan), you are on a fixed payment schedule to pay it back. That process is called amortization. Learn how to make it work for you.

Tax deductions

Unmarried filers can deduct up to $2,500 of interest paid on federal student loans every year. This may or may not be the case for private student loans.

Forbearance and deferment

If you ever need to pause your student loan payments, you can apply for either forbearance or deferment. (Learn the difference here.)

This should be a last resort, only to be explored if you have tried an income-driven repayment plan first. Although you are not required to make payments during this time, unsubsidized federal loans in deferment and any loan in forbearance will continue to accumulate interest. That said, either one of these options is preferable to going into default.

Though there are exceptions, most private student loan lenders do not offer borrowers deferment or forbearance options.

Making smart choices

Student loans may be a necessary evil, but there is plenty you can do to minimize the damage:

  • Only borrow as much as you need (yes, you can take a smaller loan than the one offered to you).
  • For federal loans, make sure you’re on the right payment plan.
  • Pay on time, every month.
  • Pay extra as often as you can.
  • Take advantage of saving opportunities (for example, tax deductions for interest paid and 0.25 percent interest rate reduction for automated payments).
  • If you’re having trouble making payments, contact your servicer immediately for help.

When you get right down to it, the most important question isn’t “How do student loans work?” but, “How do student loans work best for you?”

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Published in Federal Student Loans, Private Student Loans