How Do Student Loans Work?

It’s a fact of life that to get a college degree these days, you often have to take out loans to pay for it. Just thinking about applying for and choosing student loans can be overwhelming, but the truth is, once you have an idea of how they work, they’re a lot easier to handle.

Here’s a look at what your options are, and pitfalls to avoid.

A student loan is borrowed money that is specifically meant to pay for higher education.

There are two types of student loans:

• Federal: These are made available by the federal government.

• Private: These are available through non-federal lenders, like banks.[1]

Here’s what you should know about each type of loan:

Federal Student Loans

If student loans are necessary for you to pay for college, federal student loans are going to be your best bet. You can qualify for these by filling out the Free Application for Federal Student Aid (FAFSA). Unlike private loans, your credit score isn’t a factor here. So if you don’t have a good credit history, you won’t have to worry about finding a cosigner.[2]

“The first thing you want to do is file the FAFSA,” says Bob Collins, vice president of financial aid at Western Governors University. “It’s important to submit that federal application because a lot of institutions in the states use that same info to make award decisions on grants and gift aid.”

*You have to demonstrate financial need to qualify for Direct Subsidized Loans.[2]

The loan term depends on the repayment plan you go with (more on that later). Generally, it can range from 10 to 30 years for federal loans.[5, 6] You’ll usually also pay a loan fee for federal loans. So that percentage is taken out of your loan amount.[4]

These loans also come with benefits, like income-driven repayment plans and forgiveness programs, that can make them a safer bet than private loans.[7]

Private Student Loans

In general, you pay a specific amount each month for a predetermined number of months. If you have a variable interest rate, you could be paying different amounts from month to month.[10]

You may not have to start making payments until six months after you graduate, though. (That’s your grace period.) However, that may not be an option with some private loans or if you take more than four years to graduate.[7]

Deferment periods may have requirements, like being in school at least half-time. So be sure to familiarize yourself with those requirements. And mark down the dates when your loan payments will start to avoid surprises later on.

Federal Student Loan Repayment Plans

You can repay federal loans using the standard repayment plan. But there are also income-driven repayment plans.[5,6] These are based on your income and family size. Here are the available income-driven repayment plans for new borrowers:

• Pay-As-You-Earn Repayment (PAYE)

• Revised Pay-As-You-Earn Repayment (REPAYE)

• Income-Based Repayment (IBR)

• Income-Contingent Repayment (ICR)[5]

These plans come with a 20- to 25-year term for new borrowers and monthly payments are usually capped at 10% to 20% of your discretionary income. That income is defined as the difference between your annual income and 100% to 150% of the poverty guideline for your family size and state of residence, depending on your repayment plan.[5]

There is also a graduated repayment plan, which starts with lower payments that increase over time—typically every two years. The term under that plan is usually 10 years, or up to 30 if you have consolidated federal loans.[11]

And there’s another plan (extended repayment) that lets you have either fixed or graduated payments. In that case, you’d be paying those loans back over 25 years. You have to have more than $30,000 in federal loans to qualify for that plan.[11]

Overborrowing

“I think it’s important to look at the information that the institution is presenting to you. You don’t always have to borrow the maximum just because it’s offered to you. Think about it,” says Collins.

You might, for example, opt to use money from savings instead of taking one of your offered loans. Or that might be out of the question. You could also consider a less expensive college. The important thing is to consider your options.

Rushing the Process

There’s something about applying for student loans that can make your eyes glaze over. But you need to know what you’re signing up for if you’re going to minimize your debt.

“You only apply for financial aid once a year. Take the time to understand what your responsibilities are—then you can focus on your academics for the next year,” says Collins.

Trying to Go It Alone

Navigating the financial aid world can be overwhelming. That’s why it’s a good idea to talk to the experts. That means contacting the financial aid offices at your school of choice.

“We’re trained administrators; this is what we do for a living,” says Collins. “Don’t be afraid to reach out to your financial aid officers.”