How Do Student Loans Work?

How do student loans work? If you’re seeking the answer to this question, you’re not alone. Student loans can be a useful way to fund your education and there are many types of student loans available for undergraduate students.

Many students look to loans as a solution to their cash flow issues, but it’s important to understand exactly how student loans work.

Especially since 43.6 million borrowers currently have federal student loan debt, and the average balance is $37,718. Finding the right product for you at the lowest cost can make a huge financial difference.

So, how do college loans work? What types of loans are available? And how do student loan interest rates work?

In this article, we’ll take a closer look at how student loans work, along with their interest rates, repayment options, limitations, and more. Once you’re armed with our guide, you can move forward with confidence.

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 usually be expected to repay the loan (with interest on top) following your studies.

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 remains the same: funding 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. Plus, some lenders will even 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 terms before signing on the dotted line of your agreement. This includes your loan’s interest rate and the repayment requirements.

Most common uses of student loans

There are a variety of expenses that college students generally face. How do student loans work when it comes to covering them all? Let’s look at a few common categories of expenses that students might use their loan money for.

Tuition and fees

This, of course, is the “big one.” With tuition costing thousands (or even hundreds of thousands) of dollars over your college career, loans can make it possible for you to get through the door in the first place!

Room and board

Whether you’re bunking up in a dorm or renting a spot off-campus, student loans can help you afford housing near your school. There’s nothing more quintessentially “college” than a cozy study pad! Plus, the “board” in “room and board” means your loan can cover things like your meal plan at the cafeteria.

Textbooks, supplies, and tech

Ever cringed at the price tag on a textbook? We’ve all been there. Student loans can help you get the books and other school supplies you need. If you don’t already have a good computer, you can use your loans to set yourself up with the technology you need to get your work and research done.

Other living expenses

Life doesn’t pause just because you’re hitting the books. Student loans can lend a hand with everyday living expenses, from groceries to bus fare. Good budgeting tips for college students will help you make the most of your money!

Student loans vs. scholarships and grants

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, plus interest.

Scholarships

Scholarships are merit-based awards given for achievements, skills, or sometimes just for being you. They can come from your school, private organizations, or local businesses who want to support students in their community.

Grants

Grants are similar, but they are usually need-based instead of merit-based. Federal and state governments, as well as private organizations, may offer grants to students, with their eligibility based on their financial situation.

Of course, the ideal solution is to focus on scholarships and grants to fund your education. You might even be able to get a full-ride scholarship that covers all your college costs!

However, it’s more likely to get a partial scholarship that contributes a smaller amount toward your education. Thus, many recipients also need student loans to cover any gaps.

Types of student loans available

How does a student loan work from a logistical standpoint? To answer this properly, we’ll have 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

Most people who get student loans start by applying for federal loans. Federal student loans often offer more appealing loan repayment terms. And in general, the interest rates are more affordable compared to 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 subsidized direct 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 six-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 direct loans is that interest accumulates from the beginning of an unsubsidized loan. However, these loans still offer a low, fixed interest rate and flexible repayment terms.

3. Direct PLUS loans

With Direct PLUS loans, parents of dependent undergraduate students help cover the cost of their child’s undergraduate tuition. You’ve probably heard this type of loan referred to as a “Parent PLUS loan.” They can be a great option for parents who want to invest in their child’s education.

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 federal aid you’re eligible for. This could include scholarships and grants, as well as student loans.

Private student loans

Private loans can help you make ends meet during school if you don’t have access to federal loans or have already reached your cap.

How do college loans work from private lenders? Well, it’s pretty similar to taking out any other type of loan. You’ll borrow money from banks, credit unions, or online lenders, then repay it according to whatever terms are in your contract.

Eligibility for private student loans is often based on creditworthiness and a credit check will determine this. Since many college students haven’t established credit yet, they usually need a cosigner with good credit who is willing to help them get the loan.

Potential downsides of private student loans

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 forbearance or 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 cosigner to take out private student loans. They usually look at things like your (or your cosigner’s) credit history and credit score.

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%! Beyond that, you might be required to start making payments while you’re still in school.

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

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

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

Graduate students may be able to borrow up to $20,500 per year in subsidized loans.

Student loan limitations and key considerations

There are some other limitations to consider. First, with federal loans, the amount you borrow cannot be more than the cost of attendance determined by your school. Your school’s financial aid office should have this information.

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.

If you’re unable to afford school with federal student loans alone, 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.

Expert tip: Don’t borrow more than you need

Even if you qualify to borrow more money than you need to survive your years as an undergraduate, you should be careful about borrowing more funds than you actually require. The more debt you have, the more difficult it will be to repay down the line.

Enjoy your time at college, but maintain the mindset that student loans aren’t free money. It’s more like borrowing money from your future self. So if you can live in a cheaper apartment or buy textbooks secondhand, future you will appreciate it!

How does student loan interest work?

When it comes to interest, how do student loans work? Three key components will determine how much you pay back overall when you take out a student loan.

The principal

When you take out a loan, you’ll be required to repay those funds in full (unless you qualify for special circumstances). The principal on a loan is the base number that you owe to repay the lender without any interest.

Let’s say you borrow $5,000 a year for 4 years. That means your principal loan amount would be $20,000 total, before any interest is factored in.

The interest rate

Next, 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 applied to your principal balance.

Interest rates are always fluctuating, so there’s no simple answer for how much interest you can expect to pay. However, as of 2023, the average student loan interest rate was 5.8% among all existing borrowers (federal and private).

Unfortunately, interest payments can add up quickly. For one thing, 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.

With federal loans, the standard repayment term is ten years, but it can be extended to 25 years. Private lenders may imitate the ten-year term, set shorter terms, or allow longer spans of 20-25 years.

But remember, the longer you take to pay off your loans, the more interest you’ll accrue over time.

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 student loan loan repayment options?

So, how do student loans work when you’re planning how to pay back the money you’ve borrowed? You’ll need to create a repayment plan. As you weigh your options, it’s important to consider all the alternatives available to you. So let’s explore them now!

Loan forgiveness

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:

1. 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.

2. 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.

Payment plans

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, 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, or 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

For many college graduates, you only have a six-month grace period before you have to start repaying your loan. 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 don’t have the money to pay? Here are some things you can do:

Contact 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.

Apply for student loan deferment

Student loan deferment is a temporary pause in your student loan payments. Deferment is typically granted for specific reasons, such as returning to school, economic hardship, or unemployment.

You’ll have to reach out to your lender and complete a deferment application. It will usually ask for details about your circumstances and possibly supporting documentation to demonstrate your need.

If you’re approved, your loan servicer will specify the duration of the deferment period and any other conditions. For instance, interest may continue to accrue and add to your loan.

Switch 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.

Tackle 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.

It’s never too early to learn about budgeting. In fact, using a college student budget will ensure you don’t borrow more money than you need during your studies.

Consider refinancing

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.

Is it worth it to get a student loan?

This is a very individual decision. Student loans can be a valuable investment in your future, opening doors to better job opportunities and higher earning potential.

However, it’s essential to weigh the costs (including interest) against the potential benefits of your chosen education path. Research the average salaries in your chosen field and consider whether you’ll be able to live (and pay your loans) comfortably.

How are student loans paid back?

Student loans are typically repaid in monthly installments. You’ll work with your loan servicer to determine a repayment plan that fits your financial situation.

How do you actually get student loans?

To get student loans, start by completing the Free Application for Federal Student Aid(FAFSA). The FAFSA determines your eligibility for federal student loans (and grants, too!). Once you receive your financial aid offer, you can accept or decline the loans.

If federal loans aren’t enough, you’ll need to complete separate applications with private lenders to get the remainder of the funds you need.

Why is it so hard to pay off student loans?

High tuition costs, constantly accruing interest, and unpredictable job markets can all make it difficult for borrowers to pay off their student loans. And life just likes to throw curveballs sometimes!

For many who are struggling, the key lies in understanding their available repayment options, budgeting effectively, and looking for ways to increase their income. Most importantly, don’t get discouraged or give up.

If you enjoyed this article on how student loans work, check out this related content:

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. Just make sure you fully understand student loans and their impact on your financial future before signing up.