Loans

How Does a Student Loan Work?

A student loan is a common type of installment loan that allows students to borrow money to pay for their college education and all its related expenses. Student loans work in a relatively straightforward way, but if you are new to them, it is wise to educate yourself as thoroughly as possible. 

Student loans are becoming so common that it is difficult nowadays to find someone who doesn’t have one. So, whether you are about to take out student loans on behalf of yourself or a family member or want to learn more about the loans you currently have, we will give you a broad sweeping overview of how student loans work.

Student Loans for College in America

Over the last couple of decades, student loans have become the standard for American students. This has not always been the case, as college tuition has increased exponentially in recent decades. Additionally, a college education has become increasingly necessary to make a decent living. Currently, a majority of college students require financial aid to attend both private and public schools. 

Student loans can be taken out with the federal government in addition to private lending companies. A student loan can be taken out for undergraduate and postgraduate programs and may be used on all the expenses related to the student’s education. These expenses might include tuition, fees, books, housing, and other living expenses. 

Student loan debt must be repaid but typically not until after the student has graduated from their course of study. Some federal student loan options don’t begin charging interest until a grace period ends after graduation. 

Private lenders can offer widely different terms, so it’s crucial that you familiarize yourself with both federal and private student loans, so you know how to navigate each. 

Types of Student Loans

Student loans are available through the federal government and from private sources like credit unions, banks, and online lenders. There is a surprising variety of loan types available within the umbrella of federal student loans. 

Private student loans vary greatly, as well, depending on what company or private lender you borrow from. Despite the many types of student loans, they all essentially function like any other kind of loan with monthly installments

Federal Student Loans

Federal student loans are offered as financial aid directly from the U.S. Department of Education. Students and parents apply for these loans through a Free Application for Federal Student Aid, commonly referred to as FAFSA, which can be easily accessed and filled out online. How much and how many federal loans a student will qualify for depends on their financial need. It is common for a financial aid offer to include multiple federal student loans. Student loan borrowers can take out all the loans they are eligible for or only a portion. 

Interest rates are not based according to the borrower’s credit score but instead set by federal law. A majority of federal student loans do not require a credit check. On the whole, students can typically get a better interest rate on most federal student loans compared to student loans from private lenders. 

Direct Subsidized Loans

A direct subsidized loan is available to undergraduate students based on financial need. How much you qualify for depends on how financially dependent you are on your parents and what year of school you are in. 

Direct subsidized loans are one of the best federal student loan options available because they are subsidized by the government. This means that interest doesn’t accrue while you are in school, so they cost you less in the long run. Direct subsidized loans begin accruing interest once you graduate from college or drop below half-time status in your class load. 

Direct Unsubsidized Loans

Direct unsubsidized loans can be offered to undergraduate, graduate, and professional students regardless of the student’s financial need. Direct unsubsidized loans begin accruing interest immediately and continue to do so during all periods of payment, non-payment, and deferment. 

Direct PLUS Loans 

Direct PLUS loans are a type of federal student loan available to graduate and professional students as well as parents of dependent undergraduate students. A PLUS loan is meant to fill in the gaps that the rest of your federal financial aid does not cover. Unlike other federal loans, direct PLUS loans require a credit check. 

Direct Consolidation Loans

Federal student aid provides an option for consolidating multiple student loans into one federal loan. A direct consolidation loan allows student borrowers to have a single interest rate with one loan servicer to simplify or extend their repayment plan for a more affordable monthly payment.

Private Student Loans

Students who do not qualify for federal loans or need additional assistance can obtain private student loans from online lenders, credit unions, or banks. There are many options available for private loans, although some of the most well-known lenders include Sallie Mae and SoFi. 

Private student loans are more likely to have variable interest rates, unlike federal loans, which have fixed interest rates. In addition to this, the most competitive interest rates are reserved for students with a credit score over 670, which makes it difficult for undergraduate students to get reasonable rates as their credit is unlikely to be well-established at that age. Because of this, many private student loans for undergraduates end up requiring a co-signer.

Private student loans will not come with all the same benefits and borrower protections ensured by federal loans, which can make them more difficult and costly to repay. The best course of action is to always take the most that is offered to you in federal student loans before turning to private loans. Private student loans ought to only be relied upon when there is absolutely no other financial aid available for covering costs you cannot cover on your own. 

Applying For Student Loans

To fill out the FAFSA, you need a Federal Student Aid ID. If you are a dependent, your parent or guardian requires an FSA ID too. Completing your FAFSA application typically does not take long as it only requires some basic personal details alongside demographic and financial information. 

After you’ve been accepted to the school you plan to attend, you will be sent an award letter containing your financial aid package. Your aid package can include grants, federal work-study funds, and the federal loans available to you, including both subsidized and unsubsidized loans. You are not required to accept every federal loan you are offered if you do not need them. 

If you have maxed out your federal loan aid, you can apply for a private student loan separately. Applications vary from lender to lender for private loans as they are done independently from the FAFSA system. 

The Rise of Student Loan Debt

Student debt has gotten so out of hand in America that most are now referring to it as the student loan crisis. As of 2022, debt from federal student loans has hit a whopping $1.76 trillion. The average debt owed on student loans is $39,000 per person. This has had a massive impact on the American economy and the day-to-day lives of young people across the country. 

As can be seen from these statistics, a majority of Americans already have student loans to pay back and are simply navigating how to do so. Paying off student loans should be a high priority in the journey toward financial health and freedom, right alongside saving for retirement. 

Paying Off Your Student Loans

One benefit that comes with federal student loans, which you will not get when you take out a private student loan, is the many fantastic repayment plans to choose from. Federal loan payments have flexibility so that they can be affordable at various points in your earning potential. You are unlikely to find the same repayment plan options from private student lenders.

Federal student loans typically have a grace period of six months after graduation or drop below half-time status before the loan payments begin. The standard repayment plan is automatically implemented directly after the grace period unless you sign up for another plan first. 

Standard Repayment Plan

The standard plan assumes that the borrower will pay off their loans within ten years, and the monthly payments are calculated to reflect that. For many people, student loan payments of this size may not be affordable. However, others may attempt to pay off the loans even faster than this to save money on the interest rate charges. 

If you cannot afford the monthly payment, you will be able to apply for repayment plans that give you a monthly loan payment based on your discretionary income instead.

Income-Based Repayment

Income-based repayment, referred to as IBR, will adjust your loan payment to 10% to 15% of your discretionary income. Some borrowers even qualify for a monthly payment of $0. The remaining student loan balance will be forgiven if you haven’t paid your loans off after 20 to 25 years of paying 10% to 15% of your income.

Income-Contingent Repayment

With an income-contingent repayment plan (ICR), your monthly payments will be 20% of your discretionary income or the amount you’d pay on a fixed payment plan spanning 12 years. Any outstanding balance on your subsidized and unsubsidized loans will be forgiven after 25 years.

Pay As You Earn & Revised Pay As You Earn (PAYE and REPAYE)

The Pay As You Earn plan caps the monthly payments at 10% of your discretionary income while also ensuring that you will never pay more than you would under the ten-year standard repayment plan. Your remaining balance will be forgiven after 20 years on the PAYE plan. 

The Revised PAYE plan (REPAYE) does not have an income requirement like the other income-driven plans, and like the PAYE plan, the payment will be 10% of your discretionary income. But it’s not a guarantee that you will pay less than the standard ten-year plan. The outstanding balance will be forgiven after 20 to 25 years.

Deferment and Forbearance 

If you are experiencing financial hardship, you can get a temporary deferment or forbearance on paying your student loans. Federal student loans will typically allow up to three years of forbearance or deferment, giving you time to get back on track with a repayment plan. 

References:
How Do Student Loans Work? | RamseySolutions.com
How Do Student Loans Work? – Forbes Advisor