If you want to understand how student loans work, then you are not alone. In fact, 54% of young adults attending college took out some form of debt to pay for their education. Although many students look to loans as a solution to their cash flow issues, it is important to understand exactly how student loans work.
Without understanding how these loans work, you won’t know exactly what you are getting yourself into. Student loans can be a useful way to fund your education. But you’ll need to decide for yourself whether or not taking on certain types of student loans is worth it to you.
Today we will take a closer look at how student loans (and the interest rates attached) work. Once you know more, you can move forward confidently.
- What is a student loan
- How do student loans work
- Types of student loans
- How much can you borrow in student loans?
- How does student loan interest work?
- How do you repay a student loan: Loan repayment options
What is a student loan?
Student loans are a type of loan in which you borrow funds to pay for your education. You can secure student loan financing from both the government and private lenders. In either case, you’ll be expected to repay the loan with interest in the future.
As you dive into student loan financing, it is important to note that loans are very different from scholarships and grants. You don’t have to repay scholarship or grant funds. But you will have to repay the student loans you take out with interest.
Of course, the ideal solution is to solely focus on scholarships and grants to fund your education. However, many students 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 student loans, the purpose of funding your education remains the same.
You can use the funds to pay for your tuition, housing, food, books, student fees, and any other expenses that are essential to your education.
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. You want to however make sure you are clear on the loan repayment terms of your specific loan before signing on the dotted line.
Types of student loans
The two general categories of student loans are federal and private. Let’s take a closer look at both.
Federal student loans
Federal student loans often offer more appealing loan repayment terms; In general, federal student loans are more affordable than private student loans.
That being said, there different types of federal student loans you should be aware of:
1. Direct subsidized loans
A direct loan is a loan made directly by the U.S. Department of Education. With this loan option, if you are able to demonstrate a financial need, then the government will allow you to borrow these subsidized loans.
Basically the government will pay all of the interest your student loans accrue until six months after you leave school. When it is time for you to start making payments, you’ll be responsible for making not only your principal payments but in addition any interest after the 6-month period.
2. Direct Unsubsidized loans
If you are unable to demonstrate a financial need, then you’ll have the option to take on direct unsubsidized student loans. The government will not help you out with the interest payments at any point. Instead, the interest will start to accumulate from the beginning of the loan. However, these loans offer a low, fixed interest rate and flexible repayment terms.
3. Direct PLUS loans
This is a loan that Parents are able to take out to help cover the cost of their child’s undergraduate tuition. They can also be an option for graduate or professional students that need loans to cover their education expenses.
Applying for federal student loans
If you want to take out federal student loans, then you’ll find out if you are eligible through the Free Application for Federal Student Aid (FASFA).
On the FASFA, 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. In that letter, you’ll find out what kind of financial aid you are eligible for. That could include scholarships and grants, as well as student loans.
Private student loans
Private student loans are generally more expensive than federal student loans. However, they can help you make ends meet during school.
If you work with a private lender, then you will have less flexibility in terms of repayment. The federal government might be willing to work with you on a forgiveness plan, but private lenders are less flexible.
The terms of a private student loan can vary dramatically. You may need to undergo a more stringent application process with a cosigner to take on some private student loans. Beyond that, you might be required to start making payments while you are in school.
The biggest downside of a private student loan is that you will likely be facing higher interest rates. Since private student loans can have variable interest rates, you could be dealing with an interest rate 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:
- As an independent undergrad, you’ll be able to borrow up to $12,500 per year in federal student loans. Only $5,500 of that can be subsidized.
- As a dependent undergrad, you’ll be able to borrow up to $7,500 per year in federal student loans. But only $5,500 can be subsidized.
- As a graduate student, you’ll be able to borrow up to $20,500 per year.
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. So if you are in school for more than 6 years to complete a 4-year degree, then you would not be eligible for more 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 need. Additional student loans can be difficult to repay down the line.
How does student loan interest work?
When you take out a student loan, there are three key components:
- The principal. 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. The interest rate on the loan is the premium a lender charges for allowing you to borrow the funds. It is calculated based on your principal balance. Unfortunately, interest payments can add up quickly.
- The loan term. The final piece of the puzzle is the length of the loan term. You might find repayment terms ranging from a few years to well over a decade.
With these three numbers, you can determine how much the total loan will cost you.
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 costs of student loans can add up quickly.
How do you repay a student loan: Loan repayment options
Once you take out your student loans, you’ll need to create a plan to repay them.
If you took out federal student loans, there is an opportunity to have your loans forgiven. The federal government offers several student loan forgiveness plans. Here are the most popular options:
- Public Service Loan Forgiveness. 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 you will likely 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. This program is designed to reward teachers who work full time in low-income elementary school, secondary school, or educational services agency. You may qualify to have up to $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 details to make sure you qualify. You should contact your loan officer to make sure that you are meeting all of the requirements for forgiveness if you are pursuing this option.
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 simulation tool on the federal government’s website to explore your options further.
Here are the repayment options that you have for federal loans:
1. Standard repayment plan
In this case, you would pay the fixed amount that you owe on your loan each month. If you keep up with these payments, then you should pay off your loan in 10 years.
If you have a Direct Consolidation Loan, this option would ensure that you repay your loan within 30 years. (A Direct Consolidation Loan is a type of federal loan that combining two or more federal loans into a new loan. This new loan has a fixed interest rate based on the average rate of the loans being consolidated.)
2. Graduated repayment plan
As you first start your career, your income might be lower than after a few years of experience. This payment plan recognizes that and sets up the monthly payments accordingly.
When you first start your payments, you will start with smaller payment amounts. After two years, your monthly payment will increase. Every two years, your payment will increase until you’ve repaid the loan at the ten-year mark.
3. Extended repayment plan
If your income can not support a high monthly student loan payment, this option will allow you to stretch out your loan obligation. Instead of repaying your loan in 10 years, you’ll have 25 years to repay the loan. That will lead to lower monthly payments.
However, this option will cost you more interest over the loan term.
4. Pay as you earn repayment plan (PAYE)
In this case, you would 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, then your debt will be forgiven. However, you might have to pay income tax on the forgiven amount.
5. 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 take a huge weight off of your back if you are 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.
6. Income-contingent repayment plan (ICR)
You’ll either make a monthly payment of 20% of your discretionary income or the amount you’d pay on a 12 year fixed repayment plan. With this repayment plan, you’d pay the lesser of the two options.
7. Income-sensitive repayment plan
This is the final option. With this option, you’d make payments over 15 years based on your annual income.
Beyond repayment plans, student loan refinancing is also an option. Basically, with 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 you 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.
Is taking out a student loan right 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. If possible, seek out ways to avoid taking on any student loan debt.
Student loans can be a good way to fund your education. But make sure that you understand the impact they can have on your financial future before signing up.