Do you want to learn how student loans work? You're not alone. Many students look to loans as a solution to their cash flow issues, but it's important to understand exactly how student loans work. Why? 43.4 million borrowers currently have federal student loan debt, and the average balance is $37,113!
Student loans can be a useful way to fund your education. But there are many types of student loans available for undergraduate students, so it's important to find the right product for you.
Here, we'll take a closer look at how student loans work, along with their attached interest rates. Once you're armed with our student loans 101 guide, you can move forward with confidence.
Understanding student loans
Student loans are a type of loan available for borrowers to pay for education. You can secure student loan financing from the government or through private lenders. In either case, you’ll be expected to repay the loan (with interest on top) following your studies.
As you dive into student loan financing, note that loans are very different from scholarships and grants. The main difference? You don’t have to repay scholarships or grant funds. But you will have to repay the student loans you take out with interest.
Of course, the ideal solution is to focus on scholarships and grants to fund your education. However, many need student loans to fund any gaps.
How do student loans work?
When you take out a student loan, the process will depend on the type of loan you are pursuing. But whether you are taking out federal or private loans, the purpose of funding your education remains the same.
You may use the funds to pay for your tuition, housing, food, books, and student fees. Your loan will also cover any other essential education expenses.
Keep in mind that the loans you take out will need to be paid back within a specified time frame. Not only will you have to repay the loans, but you'll also have to pay any interest attached.
In many cases, you will not need to start making loan payments until after your graduation. In fact, some lenders will give you a grace period of a few months between your graduation and the start of your repayment.
That said, it's important that you're clear on your specific loan repayment terms before signing on the dotted line of your agreement. This includes your loan's interest rate and the repayment requirements.
Types of student loans available
The next part of our student loans 101 guide is to get into the different types of student loans. The two main student loan options available are federal and private funding. Let’s take a closer look at both, so you know exactly how student loans work.
Federal student loans
Federal student loans often offer more appealing loan repayment terms. And in general, federal student loan interest rates are more affordable than private student loans.
That being said, there are different types of federal student loans you should be aware of:
1. Direct subsidized loans
A direct subsidized loan is made directly by the U.S. Department of Education. The government will offer you one of these direct subsidized loans if you can demonstrate a financial need.
How does this work? The government will pay all of the accrued interest on your student loans until six months after you leave school. You'll then start making your principal payments and any applicable interest following this initial 6-month period.
2. Direct Unsubsidized loans
Direct unsubsidized student loans are available for students who aren't able to demonstrate a financial need. They're available for undergrads, graduates and professional students. The main difference between subsidized and unsubsidized loans is that interest accumulates from the beginning of the loan. However, these loans offer a low, fixed interest rate and flexible repayment terms.
3. Direct PLUS loans
With Direct PLUS loans, parents help cover the cost of their child’s undergraduate tuition. A similar grad PLUS loan can also be an option for graduate or professional students who need loans to cover their education expenses.
Applying for federal student loans
If you want to take out federal student loans, find out if you are eligible through the Free Application for Federal Student Aid (FAFSA).
With FAFSA, you’ll fill out your financial information and your parents’ financial information. After looking at your numbers, the school will send you an award letter highlighting the type of financial aid you're eligible for. This could include scholarships and grants, as well as student loans.
Private student loans
Private loans are generally more expensive than federal student loans. But when understanding student loans, keep in mind that they can help you make ends meet during school if you don't have access to federal loans or have reached your cap.
If you work with a private lender, you may have less flexibility in terms of repayment. While the federal government might be willing to work with you on a forgiveness plan, private lenders are less flexible.
The terms of a private student loan can also vary dramatically. You may need to undergo a more stringent application process with a co-signer to take out private student loans. Beyond that, you might be required to start making payments while you're still in school.
The biggest downside of a private student loan is you may face higher interest rates. Since private student loans can have variable interest rates, this could be as high as 18%! With that, it is important to shop around before committing to a private student loan lender.
How much can you borrow in student loans?
There is a limit to how much money you can borrow in federal student loans. Here’s the breakdown:
Independent undergraduates may be able to borrow up to $12,500 per year in federal student loans. Only $5,500 of that can be subsidized.
Dependent undergraduates may be able to borrow up to $7,500 per year in federal student loans. But only $5,500 can be subsidized.
Graduate students may be able to borrow up to $20,500 per year in subsidized loans.
Understanding student loans: Borrowing considerations and limits
There are some other limitations to consider, such as the amount you borrow cannot be more than the cost of your program.
Additionally, you are only eligible to take out federal student loans for 150% of the published timeline for your degree.
For example, if you're in school for more than 6 years to complete a 4-year degree, you wouldn't be eligible for additional student loans.
Beyond federal student loans, you’ll have some flexibility to borrow more money through private lenders. Each lender will have different limitations on how much you will be able to borrow.
Although you can likely borrow more than you need to survive your undergraduate career, you should be careful about taking out more funds than you require. Additional student loans can be difficult to repay down the line.
How does student loan interest work?
Three key components will determine how much you pay back overall when you take out a student loan.
When you take out a loan, you’ll be required to repay those funds in full. The principal on a loan is the base number that you owe to repay the lender without any interest.
The interest rate
Have you been asking the question, "how does student loan interest work?" Essentially, the loan's interest rate is the premium a lender charges for allowing you to borrow the funds. The rate is calculated based on your principal balance.
Unfortunately, interest payments can add up quickly. So, it's important to understand that interest on your loan may be capitalized, meaning that unpaid interest is added to your loan principal and compounds. In this scenario, debt quickly mounts.
The loan term
The final piece of the puzzle when it comes to understanding student loans is the length of the term. You might find repayment terms ranging from a few years to well over a decade.
Example of how student loans work
The three numbers above determine how much the total loan costs. But what do they look like in real life?
For example, let’s say you took out $20,000 in student loans over the course of your education with a ten-year term and a fixed interest rate of 6%.
With that, you’d have a monthly payment of $222. If you repaid the loan in ten years, it would cost you $26,645.
As you can see, the interest on your loan can add up quickly.
What are your loan repayment options?
So, how do student loans work when it comes to paying back the money you've borrowed? You'll need to create a repayment plan, although there may be some additional options available.
There is an opportunity to have your loans forgiven if you took out federal student loans. The federal government offers several student loan forgiveness plans. Here are the most popular options:
Public Service Loan Forgiveness (PSLF)
The PSLF will forgive the remaining balance of your student loans if you make 120 qualifying monthly payments and work full-time for a qualified employer.
If you work for non-profit organizations or a government agency, then it's possible that you qualify. Be sure to confirm your employer offers this program and that you qualify for it before assuming you'll get it.
Teacher Loan Forgiveness
The Teacher Loan Forgiveness program is designed to reward teachers who work full-time in low-income elementary schools, secondary schools, or educational services agencies. You may apply to have $17,500 of your federal student loans forgiven if you teach for five consecutive years in a qualifying school.
If you are considering either forgiveness option, find out more about the qualification details. Your loan officer will help you understand if you meet the forgiveness requirements.
The federal government offers a variety of repayment plans. The best option for you will depend on your personal situation. You can check out a loan calculator on the federal government’s website to explore your options further.
Here are the repayment options available for federal loans:
1. Standard repayment plan
With a standard repayment plan, you'll pay the fixed amount you owe on your loan each month. If you keep up with these payments, and you could pay your loan off in 10 years.
2. Direct consolidation loans
With a direct consolidation loan, you'll repay your loan within 30 years. This type of loan works by combining two or more federal loans into a new loan. This new loan has a fixed interest rate based on the consolidated loans' average rate.
3. Graduated repayment plan
A graduated repayment plan works on the basis that when you start your career, your income might be lower than after a few years of experience. The graduated repayment plan recognizes that and sets up the monthly payments accordingly.
Typically, you'll start by making smaller payment amounts. After two years, your monthly payment will increase. Your payment will increase further every two years until you’ve repaid the loan at the ten-year mark.
4. Extended repayment plan
An extended repayment plan is suitable if your income doesn't support a high monthly student loan payment. This option allows you to stretch out your loan obligation. Instead of repaying your loan in 10 years, you’ll have 25 years to repay the loan.
Although your monthly payments will be lower, this option will cost you more interest over the loan term.
5. Pay as you earn repayment plan (PAYE)
With PAYE, you'll make monthly payments equal to 10% of your discretionary income. However, the payment would never exceed the amount you would have paid under the standard repayment plan.
If there is a balance left on your loan after 20 years, your debt will be forgiven. However, you might have to pay income tax on the forgiven amount.
6. Income-based repayment plan (IBR)
This is also known as the income-driven repayment plan. A large student loan payment can dramatically impact your monthly budget. You might even have trouble paying for the essentials with a student loan taking a large bite out of your income.
The income-based repayment plan will allow you to cap your payments at 10% of your discretionary income. This can be a relief if you're struggling to put food on the table while making your student loan payments.
This is quite a popular option, so we break down everything you need to know about Income-driven repayment plans here.
7. Income-contingent repayment plan (ICR)
With the income-contingent repayment plan, you’d pay the lesser of the following two options. Either you'll make a monthly payment of 20% of your discretionary income. Alternatively, it'll be the amount you’d pay on a 12-year fixed repayment plan.
What to do if you can't repay your student loan
The honeymoon phase (where you don't repay your student loan debt) for many college graduates is only six months. Even if you haven't found regular work by this stage, you'll often need to start paying back your loan regardless. But how do student loans work if you can't? Some options are:
Contacting your loan provider
The first thing you need to do is to contact your loan provider. Being honest about your situation is the best way to learn about available options without getting deeper into financial difficulty. Find out if you're eligible for any forgiveness plans, or otherwise, learn what options are available to you.
Switching to an income-driven repayment plan
Switching to a flexible repayment plan based on your income may be a possibility. Meaning the lower your income, the lower your student loan repayments. Bear in mind that it might take longer to pay back your debt if you're not able to tackle your debt aggressively.
Tackling your budget
By slashing your expenses and increasing your income, you may discover there's more room in your monthly budget to repay your student loans on time.
Beyond repayment plans, student loan refinancing is also an option. By refinancing, you would take out another loan to cover your student loans. With your new loan, you would find a lower interest rate and terms that suit you better.
It is important to note that student loan refinancing is not the best option for everyone. But if you have private student loans with a high-interest rate, then it is something that you should consider. You can also check out more advice for student loans and the best loan resources.
Now you know how student loans work: is it the right choice for you?
A college education can help you move forward in your career. But student loans can be a drain on your personal finances for years. So, if possible, seek out ways to avoid taking on any student loan debt.
If this isn't possible, then be aware of all the available student loan options so you make the best choice for your specific situation.
Student loans can be a good way to fund your education. But make sure you fully understand student loans and their impact on your financial future before signing up.