Published in: Student Loans | April 1, 2019

How Do Student Loans Work?

Student loans can help you finance your education, but they come at a cost. Here's what you need to know before applying for one.
College student standing on stepsImage source: Getty Images.

It's becoming increasingly difficult to get by without a college education, but as tuition costs continue to rise, so does the challenge of paying for that education. While you may qualify for some grants or scholarships, only the rare student can pay for college without taking out student loans.

It can be unsettling to take on large amounts of debt when you don't yet know how you'll pay it back, but you can reduce your anxiety by understanding how student loans work and how to choose the right ones for you. Let's go over the different types of student loans, how much you can borrow, and the different repayment methods available to you.

Federal student loans

Federal student loans are most students' first stop after grants and scholarships, because they offer low, fixed interest rates and flexible repayment terms. Plus, you can usually get them without a cosigner or a credit check. But because these loans are in such high demand, you're limited in how much you can borrow.

Federal student loans may be "subsidized" or "unsubsidized." Subsidized federal loans offer the better deal, because no interest accrues while you're in school or in "deferment," i.e., a period during which you can stop making monthly payments (more on deferment and its requirements later). Eligibility for unsubsidized federal loans is based on the student's financial need, which the government determines when you fill out the Free Application for Federal Student Aid (FAFSA). Undergraduates may be entitled to up to $3,500 to $5,500 in subsidized federal student loans each year, depending on their year in school and their legal dependency status. Graduate students are not eligible for subsidized federal student loans.

If you don't qualify for a subsidized federal student loan, you may still qualify for an unsubsidized federal student loan. These are identical to the subsidized loans, except they accrue interest while you are in school or in deferment. If you don't at least make interest payments, the government will add any accrued interest to your principal balance, which means you could be forced to pay interest on interest. This can make these loans more difficult to pay off. If you can, it's best to at least make the interest payments while you are still in school or while payments are deferred so you don't end up with a larger balance than you started with.

Undergraduate students can borrow up to $5,500 to $12,500 in total federal student loans per year, depending on their year in school and dependency status. If you've qualified for subsidized federal student loans, you must subtract them from the total amount of federal loans you're entitled to; the remainder is what you can borrow in unsubsidized federal student loans.

Graduate students may borrow up to $20,500 per year in unsubsidized federal student loans; they are ineligible for subsidized loans. These are called Direct PLUS loans, and they may require a credit check.

Parents of undergraduate students can also take out Direct PLUS loans in their own names to pay for their child's education. You can borrow up to the full cost of your child's attendance, which is determined by the school, and you are responsible for paying it back -- not your child. This may be worth considering if you'd like to help your children pay for college but don't have the savings to cover the full cost. However, the interest rates on Direct PLUS loans are higher than on subsidized or unsubsidized loans for students, so you'll pay more over the long term.

Private student loans

If grants, scholarships, and federal student loans aren't enough to cover the full cost of your education, you may turn to private student loans. These are loans issued through banks and other private financial institutions. The amount you can borrow and the interest rate you'll pay are determined by the lender, and you may have to submit to a credit check and have a parent cosign with you if you cannot qualify for the loan on your own.

Interest rates on private student loans may be fixed, but they're often variable. This makes it difficult to predict how quickly your balance will accrue interest and, consequently, how challenging it will be to pay the loan off. Before you accept a private student loan, read through the terms. Pay attention to the interest rate -- namely, whether it's variable and whether there's a cap on how high your interest rate can go.

Private student loans are always unsubsidized, so you must either make interest payments while you are still in school or accept that you'll have a larger balance when you graduate, because your accrued interest will be rolled into your principal balance.

How to apply for student loans

To determine which kinds of federal student loans you qualify for, you'll need to fill out the FAFSA. You must do this for every year you wish to take out a federal student loan. For private student loans, you fill out an application with each lender. It's best to shop around for these to see which offers you the best interest rate and repayment terms (more on those below).

Student loan providers don't pay attention to what you've earned in scholarships or grants, so it may be possible to borrow the full cost of a year of higher education even if you don't need it all. Your loan provider will pay the full amount to the school, and if there's any left over after applying your grants and scholarships, the school will pay you the rest.

But it's usually best to borrow only what you need, especially if it's an unsubsidized loan. Reducing the amount you borrow reduces the amount you'll pay in interest over the lifetime of the loan. A good rule of thumb is to only borrow as much in student loans as you expect your first year's salary to be once you graduate. Make up the rest with a job and personal savings if you can. Of course, this may not always be possible, in which case you'll just have to borrow as little as you can. You don't have to borrow the full amount the lender offers you. You can ask for a lower amount instead.

Student loan repayment terms

Federal student loans allow you to defer payments while you are in school and for the first six months after you graduate. Some private student loans may give you this option as well, though others require you to make payments while you're still in school.

The standard repayment plan for federal student loans has a fixed monthly payment for 10 years. This is the best option if you can afford it, because it will reduce how much you pay overall. However, the required payments can be high, especially for someone who's just starting their career and not yet earning very much.

If you can't afford the standard repayment plan, you have other options, including:

  • Graduated repayment: You still pay off your student loans in 10 years, but the payments start out smaller and increase every two years to reflect the average person's increasing income over this time.

  • Extended repayment: This option is only available to borrowers with more than $30,000 in outstanding federal student loans. You may pay either a fixed or graduated amount, but you have 25 years to pay back what you owe.

  • Income-based repayment: This plan is for individuals with a high debt-to-income ratio. Your monthly payments rise as your income rises, but they're always capped at 10% or 15% of your "discretionary income," which is defined as the difference between your income and 150% of the poverty line for your family size and state. Payments are recalculated each year. Parents with Direct PLUS loans are not eligible for this repayment plan.

  • Income-contingent repayment: This plan is also dependent on your income. You pay the lesser of 20% of your discretionary income each month or the amount you would pay on a repayment plan with a fixed payment over 12 years. Payments are recalculated each year based on your latest income information.

  • Income-sensitive repayment: Your monthly payments will depend on your current income, but you must pay back the full balance of the loan within 15 years. Parents with Direct PLUS loans are not eligible for this repayment option.

You can choose a different strategy for every federal student loan that you have, or, if you'd rather not deal with several loans, you can roll all of them into one Direct Consolidation Loan. The federal government issues these loans, which offer many of the repayment terms listed above, though you may have up to 30 years to pay back what you borrow, depending on the size of the Direct Consolidation loan.

Private student loans may offer some of the repayment terms listed above, but it's up to the lender to decide when and how you need to start paying back your loan. This is another thing you should pay close attention to when choosing a private student loan. It may be worth going with a lender that charges a slightly higher interest rate if it offers more flexible repayment terms.

Deferment and forbearance

If you cannot make your student loan payments, you can apply for a deferment or forbearance. Both will let you temporarily stop making student loan payments, but there are slightly different qualifications. If you have a subsidized federal student loan, your loan will not accrue interest during a deferment, but it will during a forbearance. If you have an unsubsidized federal or private student loan, you'll have to pay the interest whether you get a deferment or a forbearance, or else the accrued interest will be added to your principal balance when the deferment or forbearance period is over.

Deferments are more difficult to get, but they can delay your student loan payments for up to three years, or indefinitely if you're still in school. To qualify for a deferment, you must meet one of the following criteria:

  • You're enrolled in school at least half-time.

  • You're in an approved graduate fellowship program.

  • You're disabled and enrolled in an approved rehabilitation program.

  • You're actively seeking but unable to find full-time employment.

  • You're experiencing an economic hardship.

  • You're in the Peace Corps.

  • You're on active-duty military service in connection with a war, military operation, or national emergency.

If you don't meet any of these criteria, you won't qualify for federal student loan deferment, but you may still qualify for forbearance. Private student loan servicers may offer deferment for some of the situations listed above, but they aren't required to by law. Check the terms of the student loan to see what, if any, circumstances qualify for deferment.

Lenders are legally required to grant you a forbearance in the following circumstances:

  • You're serving in a medical or dental internship or residency program and you meet certain criteria.

  • The total amount you owe each month is more than 20% of your monthly gross income.

  • You're serving in an AmeriCorps position for which you've received a national service award.

  • You're a teacher who qualifies for teacher loan forgiveness.

  • You qualify for partial repayment of your loans through the U.S. Department of Defense Student Loan Repayment Program.

  • You're serving in the National Guard and have been activated but do not qualify for a military deferment.

Mandatory forbearances are usually for 12 months, but there are times where they may be extended. There's also the "discretionary forbearance" for those who don't meet any of the above criteria. As the name suggests, it's up to the lender to decide whether to grant a discretionary forbearance. If this doesn't allow you to stop making payments altogether, it may enable you to pay a lower amount each month instead.

To request a deferment or forbearance, you must fill out the appropriate form and submit it to your lender. Don't stop making payments until you get notice that your request was approved, or else your lender will report your payments as missed, and this can hurt your credit.

Those are the basics of student loans, but if you want to know the particulars of yours, check with your lender and read through the terms of the agreement you signed.

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