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How Do Student Loans Work?

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In a Nutshell

Student loans can be offered by the federal government, local governments, or private lenders. They can be used to finance tuition, room and board, and living expenses. The rules and terms for student loans vary and the debt associated with these loans generally cannot be discharged via bankruptcy. Repayment options for federal loans differ from those available for private loans. Similarly, interest rates, grace periods, and prepayment terms differ as well. It is important to understand how the loans you're either being offered or have already taken out "work" when developing a successful plan to repay your student loan debt obligations.

Written by Elena Botella
Updated December 31, 2021

More than 40% of U.S. adults who have attended college had to borrow money to finance their education. Usually, that borrowing takes the form of a student loan. Student loans can be offered by the federal government, local governments, or private lenders. They can be used to finance tuition, room and board, and living expenses. While student loans are very common, not everybody knows exactly how they work. Learning the basics of how student loans work can help you make smart decisions about your education and financial situation. 

Federal Student Loans vs. Private Student Loans

There are many different types of student loans. Each type has its own specific rules, interest rates, and policies. All of these different loans fall into two categories: federal student loans and private student loans.  

Often, but not always, federal student loans are offered at a lower interest rate than private student loans. And federal student loans usually come with more repayment options than private student loans. Federal loans also have more protections available if you lose your job or don’t make much money after you graduate. 

But the government has borrowing limits for some types of federal student loans. In other words, there’s a maximum amount that each student can borrow from the federal government. When students choose to take out private student loans, it’s often because they have exhausted their federal borrowing limit. 

Federal Student Loans

Federal student loans are offered by the U.S. Department of Education

The U.S. Department of Education offers some loans directly to students and other loans to the parents of students.

  • Direct Subsidized Loans: Direct subsidized loans are for undergraduate students only. The federal government determines eligibility for direct subsidized loans based on financial need. The word “subsidized” means that these loans are supposed to have a lower interest rate than borrowers would normally be able to get from a private lender. To get a subsidized loan, you have to fill out the Free Application for Federal Student Aid (FAFSA) Application. The federal government also uses FAFSA applications to give out Pell Grants, and most colleges use your FAFSA to determine eligibility for other types of financial aid. 

A major benefit of Direct Subsidized Loans is that the interest on these loans doesn’t accrue while you’re in school at least half-time or for the first six months after you leave school. That’s different from Direct Unsubsidized Loans, which charge interest while you’re attending college. 

  • Direct Unsubsidized Loans: Direct Unsubsidized Loans are available to students regardless of their financial need. While only undergraduates can get subsidized loans, graduate students and professional students, along with undergraduate students, are eligible for federal Direct Unsubsidized Loans. 

  • Direct PLUS loans: Direct PLUS loans are made to graduate or professional students or to the parents of undergraduate students. Direct PLUS loans have a higher interest rate than direct subsidized and direct unsubsidized loans. As of November 2021, new Direct PLUS loans had an interest rate of 6.28%, compared to 3.73% for Direct Loans for undergraduates (both subsidized and unsubsidized), and 5.28% for Direct Unsubsidized Loans for graduate and professional students. 

Taking out a student loan is always a big decision, but it’s especially important for students and their families to be careful before choosing to take out a Direct PLUS loan. Unlike Direct Subsidized Loans and Direct Unsubsidized Loans, there is no maximum limit to how much parents can borrow under the Direct PLUS loan program. This means that it’s easy for parents to end up with more debt than they can afford to repay. And these loans’ higher interest rates make them pricier than Direct Subsidized Loans and Direct Unsubsidized Loans.

Private Student Loans

Private student loans are loans offered by anyone other than the federal government. That can include banks, credit unions, colleges or universities, local or state governments, or another type of finance company. 

While Direct Subsidized and Direct Unsubsidized loans are offered regardless of the student’s credit score, private lenders usually take a closer look at the borrower's credit score and sometimes other factors like their GPA or college major. 

Key Differences Between Federal and Private Loans

Federal student loans are dischargeable upon the death of the borrower. That means if you have federal student loans, and you die before your loan has been repaid, nobody else will be responsible for repaying your loan. Federal Parent PLUS loans are also discharged if the parent borrower passes away. 

By comparison, private student loans aren’t always dischargeable upon death. If a friend or family member co-signed your private student loan, they may be on the hook to repay the loan if you die. Even if your loan didn’t have a co-signer, in some situations, private student lenders can also collect from your spouse or estate. For this reason, some people with private student loans choose to buy life insurance to cover the cost of the loan if they pass away before their loan is paid off. 

Private student lenders usually consider a very wide range of factors to set each customer’s interest rate. Borrowers with a good credit history, high credit scores, high GPAs, or with strong co-signers, may be offered a much lower interest rate than borrowers with low credit scores, no co-signer, or students who are entering a lower-income profession. 

By comparison, federal student loans don’t use these sorts of individual factors to decide on the interest rate. In fact, federal Direct Subsidized Loans and Direct Unsubsidized Loans don’t perform a credit check to decide eligibility. 

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How Interest Works on Student Loans

The most important thing to know about student loans is that they aren’t free. Student loans are a type of debt. That means if you take out a student loan, you’re on the hook to repay that loan, with interest. Student loans from the federal government come with interest rates between 3% and 9%. Private loans can have interest rates that are lower or higher than that.

If you apply for financial aid from your college or university, the financial aid office will probably include student loans as a part of your aid package. But student loans are very different from scholarships, grants, or even work-study programs because of the student loan bills that will eventually come due. 

The interest on federal student loans accrues daily. Generally speaking, this means that the longer it takes you to repay your federal student loan, the more money you’ll eventually pay. This also means that when you’re ready to make your final payment on your student loan, you will need to double-check your actual final balance amount, which may be slightly higher than what appears on your statement, since interest gets added to your balance every day. 

Congress sets federal student loan interest rates. The rates are fixed based on the year you enrolled in college. This means that the interest rate on these federal loans won’t rise or fall. By comparison, some private student loans have variable interest rates. This means that instead of guaranteeing the borrower a single, permanent interest rate for the lifetime of their loan, the interest rate will rise or fall based on an index like SOFR, the secured overnight financing rate.

The interest on student loans is tax-deductible in some situations. 

Sometimes, borrowers decide to refinance their student loans to get a lower interest rate than what they were originally offered. If you refinance your federal student loan with a private company, you should take into account that you might lose some of the protections that federal loans offer. 

Deferment and Grace Periods

When you take out a student loan, it’s important to know when your first payment will be due. Payments on federal student loans aren’t due while you’re in school at least half-time. That’s not always true with private student loans. Many private student loan companies require you to make payments while you’re still in school.

The first payment for most federal student loans is due six months after you graduate, leave school, or switch to an enrollment that is less than half-time. The six months between graduation and your first payment is called your grace period. During your grace period, you should start to receive repayment information from your loan servicer. Federal Parent PLUS loans don’t have a grace period. Your grace period can be extended in special situations, for example, if you are called into active military duty. 

Deferment is a word that lenders use that means postponement or delay. If a private student lender offers a choice between a deferred loan and an immediate loan, the difference is generally that the first payment will be due for an immediate loan shortly after you borrow the money, while payments for the deferred loan would generally not be due until after you graduate. Private student lenders usually charge higher interest rates for deferred loans than they do for immediate loans. 

During the COVID-19 Pandemic

During the COVID-19 pandemic, the U.S. Department of Education offered temporary relief for borrowers with federal student loans. On March 13, 2020, the interest rate on all federal student loans was temporarily reduced to 0%. Payments were also temporarily suspended, which means borrowers weren’t required to make any payments. The payment suspension is scheduled to end on January 31, 2022, and interest rates will revert back to normal. Borrowers should check the U.S. Department of Education for updates. 

How To Pay Back Your Student Loan

If you have a federal student loan, that loan will be assigned to a student loan servicer. The federal government works with 11 different servicers, including Navient and FedLoan Servicing. If you’re not sure who your servicer is, you can find out by calling the Federal Student Aid Information Center (FSAIC) at 1-800-433-3243 or by visiting your Federal Student Aid account dashboard. You’ll make your loan payments directly to your servicer. You can usually do this online, over the phone, or by mail. If you sign up for automatic payments from your checking account, some servicers will offer you a discount.

If you have a private loan, you’ll have to check with your lender about how to make payments. You may make your payments directly to the lender, or the lender may assign your loans to a servicer. In both cases, payments are generally due monthly. 

Federal student loans have several payment plan options you can choose from. Under the standard repayment plan, you’ll be given a fixed monthly payment that will pay off your loan in 10 years. There are other plans you can choose from that usually have lower monthly payments but will take longer to repay. Some of these plans are based on a percentage of your income, which means if your income is very low, you may not have to make any payment at all during those months. 

But you won’t be signed up for one of those payment plans automatically. You need to enroll yourself online or by calling your servicer. If you choose the Income-Based Repayment plan (IBR), Income-Contingent Repayment Plan (ICR), the Pay-As-You-Earn Plan (PAYE), or the Revised Pay As You Earn Repayment Plan (REPAYE), you’ll be assigned a payment amount that fluctuates based on how much money you’re earning, and any outstanding balance will be forgiven after either 20 or 25 years. 

If you work for the government — including U.S., state, local, and tribal governments — or for certain nonprofit organizations, you might be eligible to have your debt forgiven after 10 years of qualifying payments under a policy called Public Service Loan Forgiveness (PSLF). To receive PSLF loan forgiveness, you generally need to make payments under an income-based repayment plan. In 2021, the U.S. Department of Education announced a temporary waiver to allow other types of loan payments to qualify for PSLF. Borrowers who want to take advantage of the waiver should submit an application before October 31, 2022.

Private student loans don’t always come with a wide range of payment plans. Most private lenders have some sort of forbearance program or hardship program available to borrowers experiencing financial distress. But these programs may only be open for short periods of time, and you may still be charged interest during this time period. 

Paying Your Loan Back Early

It can be a good idea to pay your student debt back quickly if you’re able. You can do this by making larger payments every month or by making a large payment when you have extra cash available. 

If you have multiple student loans and want to make a larger payment, you should usually direct your servicer to apply the extra payment amount to whichever loan has the higher interest rate. You may also need to tell your servicer whether you want your extra payment applied to the loan’s principal or whether you’d just like your payment applied to next month’s bill. Asking to have your payment applied to the loan’s principal will save you more money.

Federal student loans don’t come with prepayment penalties. That means the faster you repay the loan, the less interest and fees you’ll eventually be charged. You should always check to see if your private student loan has prepayment penalties, especially if you're considering trying to repay your loan early

If you’re on track to have some of your federal student debt forgiven under an income-based repayment plan, you’ll need to consider the pros and cons of paying off your loan early versus waiting until your repayment plan is finished and having some debt forgiven. 

Let’s Summarize...

Student loans are a type of debt used to pay for college tuition or living expenses while in school. The rules and terms for student loans vary. Payments are usually due every month. But if your student loan is offered by the federal government, the first payment won’t be due until after you graduate or leave college, assuming you maintain at least a half-time course load. Because student loans come with interest, and because most student loans can't be discharged in bankruptcy, you should think carefully before deciding how much to spend on your college degree. 

Written By:

Elena Botella


Elena Botella is a financial journalist and consumer advocate who lives in Washington, D.C. Her writing has appeared in American Banker, Slate and Forbes.com.

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