How Do Student Loans Work?

Getting a loan is one of the most popular ways to pay for your education. Statistics show that every year, more than 30% of undergraduate students take out loans from the federal government. With the help of a student loan, you can pay for college expenses that can’t be covered by personal savings or other forms of 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 of them 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? These are the questions we’re going to answer.

Table of Contents

Understanding of a Student Loan
What Are The Types of Student Loans?
What Can I Use a Student Loan for?
Student Loan Repayment Options
What Is a Student Loan Interest Rate And How Does It Work?
What Are Costs of Student Loans: Representative Examples
Key Takeaways

Understanding of a Student Loan

A student loan is a type of financial aid designed to make higher education more affordable. It can be used to cover a wide range of expenses associated with schooling. This may include tuition costs, books, equipment, and other school-related expenditures.

Simply put, student loans are considered a form of debt that allows students to cover their education expenses without making any upfront payments.

Student loans typically have a lower interest rate than other forms of debt. They are also easier to obtain, even if you haven’t yet built your credit or have some issues with it.

Additionally, some student loans have flexible payment schedules with deferred repayment. This means that a borrower doesn’t have to make payments until they leave college.

What Are The Types of Student Loans?

There are two main types of student aid: federal student loans and private student loans. Each type has its specifics and key features that you need to consider before making a borrowing decision. Let’s take a closer look to find out what option suits you better.

Federal Student Loans

Federal student loans are a form of aid that is backed by the federal government. These loans have fixed interest rates, flexible repayment schedules, and opportunities for student loan forgiveness. Recently they started to offer 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, they 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. This means that you’re not forced to pay interest while you’re studying. The government makes it for you to reduce the amount of debt you must repay.

Summary:

Overall, a subsidized loan is one of the most affordable options for needy students who are looking for low-cost aid.

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. There’s also the grace-period that gives you six months after you graduate to gain financial strength and choose the repayment plan.

Summary:

Summing up, direct unsubsidized loans are a good choice for students who do not have financial needs and are looking for a flexible way to finance their education.

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.

Summary:

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 get to combine multiple federal student loans into one. This 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 rate 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.

Summary:

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 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.

Summary:

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 plan that you choose. There are 8 types of repayment plans a student can choose.

1. Standard Repayment Plan

   This repayment plan is 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 payments 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)

   This plan is available for the 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?

A student loan interest rate is the value that represents the cost of borrowed money you receive from a service provider. An interest rate 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 rate on a student loan is one of the key factors that determine the overall cost of the loan. A higher interest rate 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 rate 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.

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 plan 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.

Key Takeaways

When answering the question “How do student loans work?” it’s necessary to understand what type of loan we’re talking about. Although it may seem that they have a similar working mechanism, there are plenty of factors that will affect your loan conditions and overall borrowing experience. These factors include interest rates, fees, and repayment options you choose.

Student loans are a serious financial commitment, so you shouldn’t take them lightly. First, you need to understand loan terms and conditions and decide on the type of aid you need. Also, make sure you have a plan for repayment.