How Do Student Loans Work?

How Do Student Loans Work?


11 Min Read

Getting a loan is one of the most popular ways to pay for your education. Statistics show that more than 30% of undergraduate students take out loans from the federal government every year. With the help of a student loan, you can pay for college expenses that can’t be covered by personal savings or other financial aid. But how do student loans work?

In contrast to non-refundable options like scholarships and grants, student loans are a sort of help that needs payback. You should carefully consider your options if you want to avoid getting into debt.

The two primary types of student loans are federal and private. Some can be obtained by students only, while others provide assistance for parents too. But which student loan is better? What can they be used for? And how do they affect a credit score? We will answer the following questions below.

Understanding of a Student Loan

A student loan is a financial aid that helps you pay for higher education, including all the related expenses, like tuition, equipment, books, etc. Simply said, student loans allow students to cover all that without making any upfront payments.

The next feature of student loans is their low-interest rates. Compared to other forms of debt, they are also easier to get, even if you haven’t yet built your credit or have some issues with your credit history.

What Are The Types of Student Loans?

Before applying for a student loan, you should know its types and what are their features.

Federal Student Loans

The US government provides federal student loans under certain terms and conditions. These loans have fixed interest rates, flexible repayment schedules, and opportunities for student loan forgiveness. Recently federal student loans offered income-driven payment plans, which means your monthly payments will be calculated based on your revenue.

A federal student loan is one of the cheapest options to cover your education expenses. However, federal loans also come with several limits and restrictions. In their turn, federal loans are divided into four common types.

1. Direct Subsidized Loans

If a student can confirm financial need, they can qualify for direct subsidized loans. These options were created to help undergraduate students from families at or below the poverty level pay for their education.

The government “subsidizes” the interest on these loans while the student is in school and during a six-month grace period after graduating. It means that you’re not forced to pay interest for these federal loans while you’re studying. The government makes it for you to reduce the amount of debt you must repay.

2. Direct Unsubsidized Loans

Direct unsubsidized loans are those loans that are available to undergraduate and graduate students regardless of their financial needs. Unlike a direct subsidized loan, the government doesn’t take any responsibility for paying the interest on a direct unsubsidized loan. The grace period gives you six months after you graduate to gain financial strength and choose the repayment plan.

3. Direct PLUS Loans

Direct PLUS Loans are a type of federal student aid that is aimed at helping parents of dependent undergraduate students and graduate or professional students pay for their education. These loans are available to credit-worthy borrowers. There’s no focus on your financial needs.

In other words, direct PLUS loans can be a great solution for students and parents who can’t qualify for other forms of federal aid or have already reached the ceiling. This way, they can get the remaining amount they need to cover their education expenses.

4. Direct Consolidation Loans

Direct consolidation loans represent the form of aid that borrowers can serve as refinancing federal student loans into one. It can be made to simplify the repayment process and or make your loans cheaper by lowering the amount of your monthly payment. A direct consolidation loan has an interest charge that is based on the weighted average of the interest rates on your existing student loans, rounded up to the nearest one-eighth of one percent.

Private Student Loans

Private student loans are a form of aid offered by banks, credit unions, online private lenders, and other financial institutions. They are not backed by the government and have no common terms and conditions. Some private loans have fixed rates. Other lenders may set variable interest that can fluctuate within the life of the private student loan.

Another important difference is that private loans are usually more expensive than federal forms of aid. Also, they don’t offer any grace period. While federal student loan payments are usually made after graduating, private lenders require a borrower to start paying off debt from the moment the loan was deposited in a bank account.

Private student loans work similarly to conventional personal loans. They are designed to supplement federal student loans or finance additional education-related expenses that are not covered by other financial aid.

A private student loan also has less flexibility in terms of repayment options. It may require a co-signer, especially if a student has a bad or no credit history.

types of student loans

What Can I Use a Student Loan for?

Student loans can be spent on a variety of school-related expenses. The most popular purposes are:

  • Tuition fees;
  • Books, supplies, and equipment;
  • Groceries and meal plans;
  • Living expenses, including a dorm room, rent, and utilities;
  • Transportation costs.

Private loans may have other limitations, so you need to ask a lender about them first.

Student Loan Repayment Options

While private loans should be repaid like traditional personal loans, federal student loan debt can be repaid differently. The terms will depend on the repayment plans that you choose. There are 8 types of repayment plans a student can choose.

1. Standard Repayment Plan

These repayment plans are available to all borrowers. It comes with fixed and equal amounts of loan payments within the whole loan term. You must repay the money within 10 years.

2. Graduated Repayment Plan

A graduated repayment plan comes with smaller payments at first. Then, every two years, your monthly installments start to increase. All federal student loan borrowers are eligible for this plan. The repayment period within the graduated plan is 10 years.

3. Extended Repayment Plan

If you have more than $30,000 of outstanding student debt, this plan can work for you. An extended plan comes with longer repayment terms that are up to 25 years. Thus, your monthly payment amount will be lower. Payments may be either fixed or graduated.

4. Revised Pay As You Earn Repayment Plan (REPAYE)

REPAYE is a form of income-driven payment plan that sets your monthly payments of 10% of your discretionary income. Payments are recalculated each year and may change if your income fluctuates. Also, your family size plays a role in calculating. Loan terms are 20 years for undergraduate students and 25 years for graduate and professional students. If you don’t repay the loan within these terms, you can count on loan forgiveness.

5. Pay As You Earn Repayment Plan (PAYE)

These repayment plans are available for borrowers who get loans on or after October 1, 2007, and receive a disbursement on or after October 1, 2011. Your payments will also be 10% of your discretionary income but won’t exceed the amount that you would have paid under a standard repayment plan.

6. Income-Based Repayment Plan

People who have high debt compared to their revenues can get an income-based plan. It implies that your monthly payments will be 10% to 15% of your discretionary income. The exact value will be determined based on the moment when you received your first loan. Also, your loan payment won’t exceed the amount that you would have paid under a standard repayment plan.

7. Income-Contingent Repayment Plan

The plan works similarly to an income-based plan but with a 20% payment of your income after paying taxes and covering all your personal expenses.

8. Income-Sensitive Repayment Plan

This plan allows you to repay the loan in full within 15 years, provided that the amount of your monthly payment will be 20% of your annual income before covering taxes and personal expenses.

What Is a Student Loan Interest Rate, And How Does It Work?

After the question “How do student loans work?” comes another one: how does its interest rate work? A student loan interest rate is the value that represents the cost of borrowed money you receive from a service provider. An interest charge is always expressed as a percentage of the loan amount. This value is used to calculate the amount that you must repay in addition to loan principal over the loan lifetime. But how does a student loan interest work?

The interest charge on a student loan is one of the key factors that determine the overall cost of the loan. A higher interest will result in a higher total cost, while a lower interest rate will help you save money. At the same time, a loan with a lower interest can have higher monthly payments. This is because the repayment terms also play a role.

For most types of student loans, interest rates accrue right after you receive the funds. This means that if you don’t make payments while you’re at school, you will find your balance higher than an initial loan amount (if the government doesn’t pay it for you). When you start making payments, most of the money goes to cover the interest amount, and the rest applies to your loan’s balance.

However, over time, more and more of your loan payment will cover your loan principal. Also, the interest can be capitalized. This means that the lender will accrue interest on your existing interest. This can increase your debt.

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What Are Costs of Student Loans: Representative Examples

As we’ve already found out, the exact cost of your student loan will be determined by its length, interest rate, and origination fee. Let’s compare various options to realize what will be the final loan cost depending on its type. The table below is approximate and is based on averages. Your specific total loan cost may vary depending on many factors, including your interest rate, income, interest fluctuation (for variable loans), or the type of repayment plans you pick.

Type of Loan Loan Amount Repayment Period Interest Rate Fees Total Cost
Direct Subsidized Loan $10,000 10 years 4.99% 1.057% $12,858.21
Direct PLUS Loan $10,000 10 years 7.54% 4.228% $14,899.22
Private Loan (fixed) $10,000 10 years 9.49% 0% $15,521.36
Private Loan (variable) $10,000 10 years 5.99% 0% $13,316.45

If you need a detailed accounting for your specific loan, you can use a loan calculator.

How to Apply for Student Loans?

Applying for student loans can be a complex process, but the following steps can help guide you through the process:

  1. Apply online for federal student Aid (FAFSA): It determines your eligibility for federal student help. So you may get grants, work-study programs, and federal loans. You’ll need your Social Security number, tax details, and available bank account to apply.
  2. Reread your financial aid award letter: Once you submit the FAFSA, you’ll get your school’s financial help award letter. It will outline the federal aid you are eligible for, including any types of loans for students.
  3. Qualify for private student loans: If federal student aid doesn’t cover your full educational expenses, you could try to apply for private student loans. Banks, credit unions, and other financial institutions offer private loans. You must also fill in the loan application form to apply for private student loans. Some private student loan lenders may perform a credit check and require a co-signer.
  4. Accept the suited loan offer: After comparing all the offers, you must accept the loan offer from the lender. It will imply the loan agreement signing and accepting the terms and conditions.
  5. Disbursement of funds: Once the lender approves your loan, they will disburse the funds to your school or college. The education institution will first use the funds to pay for tuition. After that, the remaining funds will be distributed to you.

How Long Does it Take to Pay Off Student Loans on Average?

The repayment terms of student loans depend on various criteria, such as the loan amount, the interest rate, the repayment plan, and your income (be it from a full-time or part-time job).

On average, it takes about 10 years to pay off student loans. However, this can vary significantly depending on the individual circumstances of the borrower. For example, those with higher loan balances or lower incomes may take longer to pay off their loans.

What Happens If You Don’t Pay Your Student Loans?

Your student loan servicer may charge you late fees or penalty charges if you miss a payment deadline. Non-payment or delinquency on student loans will be reported to the credit bureaus, damaging your credit score. It can impact your ability to obtain future loans or credit.

If you default on your student loans, your wages may be garnished to repay the debt. The government can take up to 15% of your disposable income to pay off defaulted loans.

The government or private loan providers can take legal action against you to collect unpaid student loans. This can result in wage garnishment, liens on your property or assets, or seizure of tax refunds.

Can You Get a Student Loan Without Your Parents’ Help?

Yes, it is possible to get a student loan without your parent’s help, but it may depend on your individual circumstances and creditworthiness.

If you are a dependent student, meaning your parents claim you as a dependent on their tax returns, you may need their information to complete the Free Application for Federal Student Aid (FAFSA). This information determines your eligibility for federal financial aid, including grants, work-study, and federal student loans.

However, you may not need your parent’s information on the FAFSA if you are an independent student. To be considered such a borrower, you must be at least 24 years old, be married, have dependents of your own, or be a veteran.

Key Takeaways

Before answering the question “How do student loans work?” it’s necessary to understand what type of loan we’re discussing. Although it may seem they have a similar working mechanism, plenty of factors play a significant role in the loan conditions and overall borrowing experience. It is all about interest payments, fees, and repayment options you choose.

Student loans are a serious financial commitment, especially for you as a young adult. So you shouldn’t take them lightly. Make a completely informed decision and assess your possibilities before entering this zone.

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Marsha Welch

Written by Marsha Welch

Written by Marsha Welch

Marsha Welch is a professional finance expert, qualified financial writer, and author of her own blog on financial literacy. As an author of 1F Cash Advance, Marsha want to be useful to businesses and individuals who want to modernize their wealth management or need an innovative financial planning solution.

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