How Do Student Loans Work?

A college education has long been seen as one of the surest paths to a stable, high-paying career—and in our increasingly globalized world economy, it is only becoming more important.

According to the Bureau of Labor Statistics, the average annual salary of someone who has earned a bachelor’s degree is just under $61,000 annually, compared to $37,000 for someone who has only earned their high school diploma. In addition to increased salary, college graduates as a whole enjoy lower unemployment rates, better health and other benefits.

But those benefits come at a cost: College is expensive. For the 2017-2018 school year, the average cost of attending college—including tuition, fees, and room and board—was $20,770 for public, in-state universities and $50,900 for private universities. Multiplied by four years, and the total cost of a four-year degree could be anywhere between $83,000 to $203,000.

With a price tag like that, it’s little wonder that up to 65 percent of today’s college graduates will find themselves needing to borrow an average of $28,650 in student loans in order to pay for college, according to The Institute for College Access & Success (TICAS).

We answer some of the most common questions about student loans so that you can make an informed decision regarding the role they play in financing your education.

What is a student loan?

A student loan is money that someone borrows in order to pay for their college education. It can be used to cover the cost of tuition, fees, room and board, and other expenses related to higher education.

To truly understand what a student loan is and how it works, you first need to understand four terms that generally apply to all loans: principal, interest, term, and balance.

Principal refers to the amount of money that you originally borrow.

Interest is the fee that the lender charges you for borrowing the money—it’s how they make money. Typically, interest is represented as an annual percentage rate (APR) of the principal. Interest rates on student loans can be fixed (meaning it will never change) or variable (it may change periodically, whether monthly, quarterly, or annually).

Term refers to the period of time over which you will repay the student loan, including both principal and interest. Most student loans are repaid over a 10-year term, though other terms are also common.

Balance refers to how much money you have left to repay. It includes both the principal, as well as any accrued, unpaid interest. So long as you make your minimum monthly payments, your balance should lower from month to month.

What are the types of student loans?

Student loans come in two main varieties: federal and private student loans. While both types of student loans can be used for the same thing—paying for college and its miscellaneous expenses—there are a number of important differences between the two.

Federal Student Loans

Federal student loans are what most of us think of when we think about student loans. These loans are offered to borrowers directly by the federal government and managed by federal student loan servicers (such as Navient). Because of this, many of the specifics of federal student loans are dictated by law.

The interest rates for federal student loans are set annually by Congress. Current interest rates (as of July 2019) range from 4.53 percent for undergraduate student loans to 6.08 percent for graduate student loans and 7.08 percent for parent loans. Federal student loans carry fixed interest rates.

Newly issued federal student loans may come in the following varieties:

Direct Subsidized Loans

These loans are based on financial need. Direct Subsidized Loans will not accrue interest while you are a student, during your grace period, and any time you place the loan in deferment. These are sometimes referred to as Subsidized Stafford Loans.

Direct Unsubsidized Loans

Direct Unsubsidized Loans are not based on financial need. Compared to subsidized student loans, unsubsidized student loans will accrue interest while you are a student, during your grace period, and anytime your loan is placed in deferment. These are sometimes referred to as Unsubsidized Stafford Loans.

Direct PLUS Loans

Direct PLUS Loans are offered to graduate and professional students. They can be used to cover any expenses not covered by other financial aid.

Direct Consolidated Loans

These loans are designed to replace multiple federal student loans with a single new loan. Consolidating your student loans will not change your interest rate, though it may lengthen your repayment term.

Up until September of 2017, undergraduate and graduate students who demonstrated exceptional financial need could borrow loans directly from their school. These loans were called Perkins Loans, and carried a fixed interest rate of 5 percent. The program failed to renew in Congress and is currently not active.

The total amount that you can borrow in federal student loans each year depends on a number of factors, including the year of your education and whether or not you are being claimed as a dependent.

As of 2019:

• Undergraduates may borrow a maximum of $5,500 to $12,500 in Direct Loans each year.

• Graduate students may borrow a maximum of $20,500 in Direct Loans each year, and up to the remainder of their college expenses in PLUS loans after that.

• Parents of dependent undergraduate students may borrow up to the remainder of their child’s college costs not covered by other financial aid.

In order to qualify for federal student loans, you must complete the Free Application for Federal Student Aid (FAFSA) each and every year for which you need financial aid. Completing the FAFSA will also allow you to apply for grants and federal work study programs.

General eligibility requirements for federal student loans include that you:

• Demonstrate financial need

• Be a U.S. citizen with a valid Social Security number, or an eligible non-citizen

• Be registered with the Selective Service (if you are a male)

• Be enrolled or accepted to an eligible degree- or certificate-granting program

• Be enrolled as at least a half-time student

• Be able to demonstrate satisfactory academic progress in college

It is important to note that credit score and credit history are not considered when applying for undergraduate federal student loans. Graduate and professional students, as well as parents borrowing for their children, will need to pass a credit check.

Private Student Loans

While federal student loans are offered by the federal government, private student loans are offered to borrowers by private corporations and lenders. They are often leveraged by borrowers for whom federal student loans do not cover the full cost of attending college.

Because private student loans are not controlled by the same laws that govern federal student loans, most of the terms of the loan are set by the private lender, and may vary substantially from borrower to borrower.

Interest rates carried by private student loans will typically be much higher than an equivalent federal student loan. The exact rates will depend on a number of business factors, as well as the borrower’s credit history and whether or not they are applying with a cosigner. Interest rates may be either variable or fixed.

Similarly, borrowing limits are typically much higher for private student loans than for federal student loans, though the exact amounts will depend on the lender.

Eligibility requirements for private student loans are generally more stringent than for federal student loans. In order to determine your creditworthiness, a private lender will check your credit score. Borrowers who do not have much of a credit history will need a cosigner in order to qualify for a loan.

How do you repay your student loans?

Your student loan repayment options will vary substantially depending on whether you have borrowed federal or private student loans. Generally speaking, federal student loans bring many more repayment options compared to private student loans.

Repaying Federal Student Loans

All policies regarding the repayment of student loans are set by law, and may vary depending on the exact type of student loans that you have borrowed.

If you’ve borrowed Federal Direct Student Loans, you are not required to make any payments while you are enrolled at least half-time as a student. (You may, however, choose to make interest-only payments or full payments while a student in order to avoid interest capitalization and reduce your balance.) Otherwise, you will need to begin making payments once your grace period has ended, typically six months after you have either graduated or fallen below at least half-time student status.

PLUS loans, on the other hand, do not carry any grace period. Once the loans have been dispersed, you will need to begin making payments.

Though federal student loans are issued by the federal government, the government does not manage the day-to-day business of collecting payment or otherwise supporting borrowers. That task falls to the nine federal student loan servicers:

• Navient

• Nelnet

• OSLA Servicing

• MOHELA

• CornerStone

• FedLoan Servicing (PHEAA)

• Granite State (GSMR)

• Great Lakes Educational Loan Services

• Edfinancial

Currently there are eight different repayment plans for federal student loans. Certain repayment plans will offer forgiveness options once a minimum number of payments have been made.

Standard repayment

With the standard repayment plan, you will make 120 equal payments over the course of 10 years. This is the default payment plan for federal student loan. Compared to the other repayment plans, standard repayment will typically allow you to save the most money in interest charges.

Graduated repayment

With graduated repayment, monthly payments are lower at first, but increase over time (typically, every two years). The idea is that your monthly payments will grow along with your salary. With graduated repayment, you will pay off your loans within 10 years.

Extended repayment

With extended repayment, you will pay off your loan within 25 years. Payments may be fixed or graduated. To qualify for extended repayment, you must have more than $30,000 in federal student loans. Opting into this repayment plan will give you lower monthly payments, but will cost more in interest over the life of the loan.

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

Both of these repayment plans limit your monthly payments to 10 percent of your discretionary income (the money you have left over from your post-tax income after paying for necessities), which is calculated each year.

Income-Based Repayment (IBR)

With Income-Based Repayment, your monthly payments will be 10 percent of your discretionary income if you are a new borrower on or after July 1, 2014. Those with older loans will have monthly payments equal to 15 percent of their discretionary income. Monthly payments will never exceed what you would pay according to standard repayment.

Income-Contingent Repayment (ICR)

Your monthly payment will be the lesser of either 20 percent of your discretionary income or the monthly payment you would make on a repayment plan with a fixed payment over 12 years.

Income-Sensitive Repayment

Like the other income-based repayment plans, the Income-Sensitive Repayment plan calculates your monthly payment based on your annual salary. Unlike the others, though, you will repay your loan in full within 15 years.

Repaying Private Student Loans

If you have borrowed private student loans, you will make your monthly payments directly to the lender dependent upon the schedule that you agree to when you sign for the loan. While the exact repayment options will depend on your lender, four common options include:

Immediate repayment

You will be required to make full payments (both principal and interest) once your loan has been disbursed, even while you are a student.

Interest-only repayment

While you are a student, you will be required to make interest-only payments. This will prevent your loan balance from growing while you earn your degree, saving you money in the long run.

Partial-interest repayment

You will make monthly payments designed to pay a portion of the interest that accrues while you are in school. This will limit how much your loan balance grows while you are a student.

Full deferment

You won’t be required to make any payments while you are a student, though interest will accrue.

What if you can’t make your payments?

Federal student loan borrowers who are experiencing difficulty making their payments may be able to take a break from making payments by placing their loans in deferment or forbearance.

Both of these options allow you to temporarily pause your student loan payments. The primary difference is that during deferment, subsidized student loans will not accrue interest, while they will accrue interest during a forbearance. (Unsubsidized student loans will accrue interest during both deferment and forbearance.)

Aside from deferment and forbearance, you can also speak to your student loan servicer to determine whether or not switching to a different repayment plan could help.

Borrowers of private loans likely have fewer options. Though some private lenders may offer deferment or forbearance options, they are under no obligation to do so, and private forbearance will typically be much shorter than federal options.

Regardless of whether you have private or federal student loans, if you believe that you may miss a student loan payment, you should immediately call your lender or servicer in order to understand the different options that may be able to help you avoid missing a payment and damaging your credit score.