Differences Between Subsidized and Unsubsidized Student Loans

If you’re interested in getting a federal student loan, this article can help. The Federal Direct Student Loan (formerly known as the Federal Stafford Loan or by its official name: William D. Ford Loan), is generally awarded to any student who submits a Free Application for Federal Student Aid (FAFSA). Federal student loans are available in two formats — subsidized and unsubsidized. This article discusses some aspects of subsidized and unsubsidized student loans and explains how they differ.

Options: Subsidized and Unsubsidized Federal Direct Student Loans

The Federal Reserve estimates that Americans owe an astonishing $1.73 trillion in student loans. Student loan debt is a major concern among Americans, so student borrowers must make the wisest choice possible when selecting any loan to pay for higher education. As a borrower, the type of loan or loans you get will be a major factor in determining how much debt you must repay after you finish school.

Similarities of Subsidized and Unsubsidized Student Loans

To be eligible for either a subsidized or an unsubsidized loan, a student must:

• Be a U.S. citizen, national, or permanent resident

• Be enrolled in school at least half-time

• Not have defaulted on a previous student loan nor owe a refund to any previous aid program

• Maintain satisfactory academic progress while in school

Both subsidized and unsubsidized loans have the same fixed interest rate. Congress sets this interest rate for the upcoming academic year's loans annually each May. This interest rate is fixed for the life of the loan.

With both types of loans, you must pay an origination fee. Instead of paying this fee directly, the federal government subtracts the fee from the loan amount before giving you the funds. 

You may be eligible for more money than you need to borrow. You aren’t required to borrow the total amount of student loans you’re offered. 

You must also complete entrance counseling and sign a Master Promissory Note before receiving initial loan funds for both types of loans. Finally, you must submit a FAFSA each year to receive Federal Direct Student Loans. 

You will have several repayment options when your repayment period begins.

Overview of Federal Subsidized Loans

In short, federal direct subsidized loans have slightly better terms than unsubsidized loans. Subsidized loans are only available to undergraduate students with financial need.

Subsidized loans have rules about:

• The length of time you’re eligible to take out loans.

• The annual amount you can borrow.

• The total lifetime amount of loans you can get. 

First-time borrowers (on or after July 1, 2013) are eligible to apply for and receive subsidized loans until 150% of the published length of their academic program elapses. For example, if you’re enrolled in a four-year program, you’re loan eligibility period is six years. If you’re enrolled in a two-year program, your loan eligibility period is three years.

The school you’re enrolled in will determine how much you can borrow each year. The loan amount can’t exceed your financial need. The annual limit of a subsidized loan varies, but subsidized loans typically have lower loan limits than unsubsidized loans. For example, at the time of this writing, first-year dependent undergraduate students were eligible to borrow up to $3,500 in subsidized loans versus $5,500 in unsubsidized loans. The aggregate loan limit for a student's entire undergraduate education is $23,000.

Interest and Repayment for Subsidized Loans

The U.S. Department of Education pays the interest on a subsidized student loan as long as you’re in school at least half-time. It continues to pay interest for the first six months after you leave school and if you get a loan deferment. Since this interest is being paid, it isn’t added to your loan, which saves you money in the long run. 

6-Month Grace Period

Each subsidized loan has a six-month grace period, which means you don’t have to start making loan payments until six months after you:

• Graduate,

• Drop below half-time enrollment, or 

• Leave school entirely. 

The Department of Education pays the interest on your loan(s) during this period. This is the main reason that federally subsidized loans are less costly over time than unsubsidized loans, where the borrower is responsible for paying the interest that accrues during the six-month grace period.

Deferment vs. Forbearance

The federal government offers repayment relief if you’re experiencing short-term financial difficulties. In specific circumstances, you may qualify for a deferment or a forbearance that will temporarily stop, delay, or lower your monthly payment. Your servicer will determine your eligibility and tell you what information is needed to process the deferment or forbearance. 

A deferment allows you to suspend your student loan payments. If you’re granted a deferment for an unsubsidized federal student loan, you’ll be responsible for paying the interest that accrues during the deferment period. You don’t have to pay this interest during the deferment, but if you’re able it’ll help alleviate your financial burden. If you have a subsidized federal student loan, the federal government pays the interest on the loan while your payments are deferred.

If you don’t qualify for a deferment, you can apply for a loan forbearance. For most types of forbearance, you’ll have to submit a request with supporting documentation to your loan servicer. There are two types of student loan forbearances, general (discretionary) and mandatory. 

• For a discretionary forbearance, your loan servicer decides whether to grant you a forbearance. 

• With a mandatory forbearance, your loan servicer must grant the loan forbearance if you qualify. Your loan servicer plays no part in the forbearance decision. There are specific eligibility criteria for mandatory forbearance.

Because of the impact on interest and potential loan forgiveness, it might be worth exploring another repayment plan before you consider deferment or forbearance. 

In most cases, interest continues to accrue during the deferment or forbearance period. This means your loan balance will continue to increase, and you’ll pay more over the life of your student loan. There are some rare exceptions to this, including the forbearance offered due to COVID-19 or if you have a subsided loan in deferment (where the government pays the accrued interest).

If you’re seeking loan forgiveness for any of your student loans, any period of deferment or forbearance generally doesn’t apply to your forgiveness requirements. Unfortunately, this means you’ll stop making any progress toward loan forgiveness until you resume repayment of your loan(s).

Overview of Federal Unsubsidized Loans

Direct Unsubsidized Loans are available to undergraduate and graduate students regardless of financial need. Your school determines how much you can borrow based on your cost of attendance and other financial aid that you receive. There is no time limit to take out unsubsidized loans. You’re responsible for paying the interest on an Unsubsidized Direct Loan during all periods.

Annual loan limits vary, but unsubsidized loans typically have higher loan limits than subsidized loans. At the time of this writing, a first-year dependent undergraduate student can borrow up to $5,500 in unsubsidized loans. The aggregate unsubsidized loan limit for the entire time a student is enrolled in school — also called the maximum eligibility period — is: 

• $31,000 for dependent undergraduate students,

• $57,500 for independent undergraduate students, and 

• $138,500 for graduate students (graduate students are automatically considered independent). 

The Department of Education considers you a dependent student if you depend on a parent/guardian for financial support like food and housing. If you’re a dependent student, you must report your parents’ or guardians’ income on your FAFSA application. As a result, independent students typically receive significantly more financial aid than dependent students.

Interest and Repayment for Unsubsidized Loans

Interest begins accruing on an unsubsidized student loan as soon as the lender disburses the loan and continues during all periods, including:

• While you’re enrolled in school,

• During the grace period, and 

• During any periods of nonpayment like deferment or forbearance.

You’re responsible for paying any accrued interest. If you decide not to pay the interest on an unsubsidized loan while in school, during the grace period, or during deferment/forbearance periods, interest will accrue and be capitalized. This means it gets added to the original loan amount.

Unsubsidized loans also have a six-month grace period. This means no loan payments are due until six months after you graduate, drop below half-time enrollment, or leave school altogether. But unlike with subsidized loans, interest will continue to accrue and be capitalized during the unsubsidized loan’s grace period. 

Repaying Your Federal Student Loans

Typically, you select or are assigned a repayment plan when you first begin repaying your student loan(s). You can change repayment plans at any time at no cost. Contact your loan servicer if you want to discuss repayment plan options or change your repayment plan.

You can choose a repayment plan that’s standard, graduated, or extended. All borrowers are eligible for the standard and graduated repayment plans. But you must have more than $30,000 in outstanding Direct Loans to qualify for an extended repayment plan. 

If you enroll in the standard plan, your monthly payment will be a fixed amount that ensures your loans are paid off within 10 years for Direct Loans or 10-30 years for Consolidation Loans. With the graduated repayment plan, payments start out lower and increase gradually, usually every two years. Again, payments are for an amount that will ensure your loans are paid off within 10 years for Direct Loans or 10-30 years for Consolidation Loans.

Income-Driven Repayment Plans

You can also choose to enroll in an income-driven repayment (IDR) plan. An income-driven repayment plan refers to any federal student loan repayment program that ties your monthly loan payment to your taxable income. To determine our payment, your loan servicer will also take into account:

• Your family size,

• The type of loans you have, and

• The state where you live.

Currently, the federal government offers four different types of IDR plans. All four are based on student loan borrowers paying a percentage of their discretionary income for a certain number of years. Most plans define discretionary income as your adjusted gross income (AGI) from your federal tax return minus 150% of the federal poverty guideline for your state and family size. At the end of the IDR plan payment term, the federal government forgives any unpaid balance left on your loan, which means that you don’t have to repay it.

IDR plans usually result in lower monthly loan payments than the standard repayment plan. Depending on your income, your payment could be significantly lower, even as low as $0 per month. The type of plan you choose determines the length of the repayment plan term and the percentage of your discretionary income you’re required to pay. Payments for all four plans are recalculated each year based on your income and family size. You must update your income and family size each year, even if they haven’t changed. 

The four IDR plan types are:

Pay As You Earn (PAYE) Plan

To use a PAYE Plan, you must be a new borrower on or after Oct. 1, 2007, and must have received a disbursement of a Federal Direct Loan on or after Oct. 1, 2011. Your monthly payments are 10% of your discretionary income but never more than the amount you would’ve paid under a standard repayment plan. Both Direct Subsidized and Unsubsidized loans are eligible for this repayment plan.

Revised Pay As You Earn (REPAYE) Plan

Any Direct Loan borrower with an eligible loan type may choose the REPAYE plan. Your monthly payments will be 10% of your discretionary income. If you're married, your income and your spouse’s income or loan debt will both be considered whether you file your taxes jointly or separately. 

Any outstanding balance on your loan will be forgiven if you haven't repaid your loan in full after 20 years (if you took all loans for undergraduate study) or 25 years (if you took any loans for graduate or professional study). Both Direct Subsidized and Unsubsidized loans are eligible for this repayment plan.

Income-Based Repayment (IBR) Plan

You must have high debt relative to your income to use the Income-Based Repayment Plan (IBR). Your monthly payments will be either 10% or 15% of your discretionary income, based on when you received your first student loans. Your payment won’t ever be more than you would’ve paid under the 10-year standard repayment plan. Your spouse's income or loan debt is only considered if you file a joint tax return. Any outstanding balance on your loan will be forgiven if you haven't repaid your loan in full after 20 years or 25 years, based on when you received your first student loan. 

Income-Contingent Repayment (ICR) Plan

Any Direct Loan borrower with an eligible loan type may choose this plan. Your monthly payment will be the lower of 20% of your discretionary income or the amount you would pay on a repayment plan with a fixed payment over 12 years, adjusted according to your income.

Your spouse's income or loan debt will be considered for an Income-Contingent Repayment Plan (ICR) only if you file a joint tax return or you choose to repay your Direct Loans jointly with your spouse. Any outstanding balance will be forgiven if you haven't fully repaid your loan after 25 years. Both Direct Subsidized and Unsubsidized loans are eligible for this repayment plan.

Federal Student Loans vs Private Loans

Federal student loans are government loans that contain terms and conditions set by federal law. Federal student loans have advantages like fixed interest rates and income-driven repayment plans that many private student loans don’t offer. Private loans are made by private institutions like banks, credit unions, and state-based or state-affiliated organizations. The lender, rather than federal law, sets its terms and conditions. Private student loans are generally more expensive than federal student loans.

If you have a choice between a federal student loan or a private student loan, the federal student loan generally should be your first choice. Why? Private student loans usually have higher interest rates that may be variable, and you’ll need a cosigner if you have fair or poor credit. Unsubsidized and subsidized federal loans offer more repayment and forgiveness options than private loans.

Payments for federal loans aren’t due until after you graduate, leave school, or change your enrollment status to less than half-time. Many private student loans require borrowers to make payments while they’re still in school. Also, private student loans often aren’t subsidized, which means you’ll have to pay all the interest on the loan.

A private loan is only worth considering if you need to fill a financial gap that remains that your federal student loans haven’t covered. If you need to take out a private student loan, compare all the loan terms and conditions and try to choose loans that offer repayment options that include deferment/forbearance.

In some cases, you may be able to get rid of your student loan through loan forgiveness, cancellation, or discharge. The terms forgiveness, cancellation, and discharge have nearly identical meanings but are used differently for student loans. For example, if you’re no longer required to make payments on your student loan(s) because of an employment issue, this is generally called forgiveness or cancellation. If you’re no longer required to make payments on your student loan(s) because of other circumstances like a total and permanent disability or the closing of the school where you received your loans, this is generally called discharge.

Let's Summarize...

The federal government offers two types of student loans: subsidized or unsubsidized. A borrower’s eligibility for a subsidized loan is based on financial need. Borrowers aren’t required to show any financial need to qualify for an unsubsidized loan.

Student borrowers must repay both subsidized and unsubsidized loans with interest, though the federal government covers some of the interest payments on subsidized loans. In effect, meeting the qualification requirements for a subsidized loan will typically result in students paying less over the term of the loan than they would with an unsubsidized loan.