How Do Student Loans Really Work?

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Our team at Student Loan Hero works hard to find and recommend products and services that we believe are of high quality and will make a positive impact in your life. We sometimes earn a sales commission or advertising fee when recommending various products and services to you. Similar to when you are being sold any product or service, be sure to read the fine print understand what you are buying, and consult a licensed professional if you have any concerns. Student Loan Hero is not a lender or investment advisor. We are not involved in the loan approval or investment process, nor do we make credit or investment related decisions. The rates and terms listed on our website are estimates and are subject to change at any time. Please do your homework and let us know if you have any questions or concerns.

how do student loans work

Paying for a higher education can feel like a challenge. In fact, 70% of colleges in the United States are unaffordable for most Americans — unless they get student loans.

If you are worried about paying for school, one of the best questions you can ask yourself is this: How do student loans work?

The good news is that we’ve got answers. Here’s what you need to know about the ins and outs of using student loans to pay for school.

How are student loans funded?

As of 2017, there is more than $1.48 trillion in outstanding student loan debt. Overall, student loan debt is carried by more than 44 million borrowers. Where, exactly, does 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.

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

 

How do you get federal 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.

How do student loans work (federal)?

Once you receive your financial aid letter, you need to decide if you will accept the package. Understanding how federal student loans work can help you decide whether they are right for you.

One of the benefits of federal student loans is the fact you don’t need a credit check in most cases. Only PLUS loans require a credit check. Otherwise, anyone who attends school can receive federal student loans. No need to prove income, credit standing, or even get your parents to cosign.

Realize that you will pay interest on student debt. With federal loans, the interest rate is set by Congress each year. Each academic year, you get a new loan, with an interest rate that remains fixed for the term of the loan. By the end of your time in school, you will have several student loans with different interest rates.

With a subsidized student loan, the federal government pays 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 the whole time you are at college. At the end, the accrued interest gets added to the principal balance at the end of your grace period.

When that happens, you end up 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.

How do private student loans work?

When you receive your federal aid letter, it may also include a list of private student loan lenders they recommend. Even if you don’t receive information about private student loans in the aid letter, it’s important to be aware of the option.

Private student loans require a direct application to the bank, credit union, or other lender. Qualifying will likely depend on your credit history and may require a cosigner.

Interest rates for private student loans 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. Carefully consider the options. In some cases, private loans can make sense — especially if you qualify for an interest rate lower than what’s being charged for federal loans.

 

Understand, though, that 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).

Check with your lender to see if you can defer your student loan repayment until after you graduate. Some private lenders even offer a grace period that you can take advantage of.

How does student loan repayment work?

After you leave school, it’s time to begin repaying your loans. With private loans, it’s pretty straightforward. You just make payments. If you have a grace period, you might be able to wait up to six months until making your first payment.

With federal student loans, though, you have more options. Here are a few things you need to know as you begin repaying your student debt:

Income-driven repayment for federal loans

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.

Income-driven repayment limits your monthly obligation to10% of your discretionary income. This allows you to better manage your student loans while balancing other aspects of your budget.

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, even with the downsides to income-driven repayment, it’s still better than 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.

For private student loans, the servicer is often the same as the lender. However, it’s not uncommon for a lender to sell your loan to someone else. Pay attention so you know who has your loans.

With federal loans, though, you will be assigned a servicer when you graduate. You can find your servicer by using the National Student Loan Data Base.

Automating payments

You can have your federal or private loan servicer automatically deduct your loan payment each month from your bank account. You will never miss a payment, and you might also qualify for an 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

It’s possible to deduct up to $2,500 of interest paid on qualifying student loans from your income. Watch for the 1098-E to arrive from your lender. If you access your account online, you can usually find tax documents on your lenders website and download them.

Forbearance and deferment

If you ever need to pause your student loan payments, you can apply for either forbearance or deferment.

This should be a last resort, only 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 default.

Not all private student lenders offer forbearance or deferment options. However, there are some private lenders that offer hardship programs designed to provide temporary relief if you can’t make payments.

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).
  • If you have federal loans, make sure you’re on the right payment plan after you finish school.
  • Pay on time, every month.
  • Pay extra as often as you can.
  • Take advantage of saving opportunities like interest rate reductions for automatic payments, tax deductions, and the possibility of refinancing your student loans to a lower rate.
  • 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 rather, “How do student loans work best for you?”

Meredith Simonds contributed to this article.

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Our team at Student Loan Hero works hard to find and recommend products and services that we believe are of high quality and will make a positive impact in your life. We sometimes earn a sales commission or advertising fee when recommending various products and services to you. Similar to when you are being sold any product or service, be sure to read the fine print understand what you are buying, and consult a licensed professional if you have any concerns. Student Loan Hero is not a lender or investment advisor. We are not involved in the loan approval or investment process, nor do we make credit or investment related decisions. The rates and terms listed on our website are estimates and are subject to change at any time. Please do your homework and let us know if you have any questions or concerns.