Everything You Need to Know About How Student Loans Work

How Student Loans Work

Everything You Need to Know About How Student Loans Work

Published May 11, 2020

How Student Loans Work

A student loan is money borrowed from the government or a private lender to pay for college. The money is used to pay for tuition, room and board, books, and other fees. The amount borrowed will vary by student and the amount approved, by lender. The loan must be paid back along with the interest that builds over time.

Many students aren’t familiar with how student loans work, how much they owe, or how the loans can affect their future. They believe if you want to attend college, you’re going to have to take out some loans to pay for it; but few know the reality of student debt after graduation.

With a $1.6 trillion student loan crisis in our country, it’s critical for families to gain a full picture of how student loans work, and which loans, if any, are best suited to their needs.

Types of Student Loans

There are three basic types of student loans: federal government loans, state student loans, and private student loans.

In addition, there is a unique category of interest-free student loans available to some students. For more information on these, follow this link: Are Interest-Free Student Loans Available?

Federal government loans

Federal loans offer fixed rates, along with the best protections and many repayment options. There are direct loans, which are either subsidized or unsubsidized, and PLUS loans, which are usually taken out by the parent or graduate student.

Direct Subsidized Loan: These undergraduate loans for students are awarded based on financial need after completing the FAFSA. The government pays the interest while the student is in school and there is a six-month grace period once they leave school or graduate before repayment starts and interest starts accruing.

Direct Unsubsidized Loan: These loans are for undergraduate or graduate students who do not have demonstrated financial need; but in order to qualify, the student must complete the FAFSA. The government does not pay the interest while in school—interest starts building from the minute the loan money is disbursed.

Direct PLUS Loans: These loans can be taken out by either a parent or an independent graduate student. You can apply by completing the FAFSA and the borrower’s credit will be reviewed upon application. A PLUS loan carries the highest fixed interest rate of any federal loan.

State Student Loans

In addition to federal student loans, your student should also explore state student loans from state agencies as another source of money to borrow for college.

State loan programs often offer lower interest rates sometimes with in-school deferments, flexible repayment options after graduation based on income, loan forgiveness for public service, and deferment for financial hardship.

Some state programs offer the same interest rate to all borrowers, regardless of their credit score, and offer fixed interest rates. Each state will provide information on their specific requirements, but the fundamental requirement is residency—either a resident of the state or an out-of-state student enrolled in a college within that state.

Private Loans

You should always consider federal loans before opting for private student loans since the repayment terms, rates, and other features can be very different.

There are private loans available for parents and students with both fixed rate and variable rates.

Private loans are available from banks, credit unions, and state agencies.

Private Student Loan: These loans require a credit check which includes credit history and credit score. Without sufficient credit rating, the loan will require a cosigner. Repayment options are much stricter than federal loans and most lenders don’t offer deferment or forbearance.

Private Parent Loan: As PLUS interest rates increase, more parents are turning to private lenders to finance their student’s education. Rates will vary between lenders and it’s smart to compare lenders. These rates are based on your financial and credit history and are not the same for everyone.

How Much Can You Get?

­­­­­The college determines the loan types and the loan amount you are eligible to receive each academic year based on the FAFSA.

There are limits on the loan amounts based on what year you are in school, and whether you’re a dependent or independent student.

Federal Student Loan Limits

There are both annual and aggregate loan limits for these loans. The aggregate limit is the total amount of federal student loan debt you can borrow throughout your undergraduate and graduate years.

Dependent undergraduate student loan limits:

  •      First year-$5,500 overall; $3,500 subsidized
  •      Second year-$6,500 overall; $4,500 subsidized
  •      Third year and up-$7,500 overall; $5,500 subsidized
  •      Total limit – $31,000 overall; $23,000 subsidized

 Independent undergraduate student loan limits:

  •      First year-$9,500 overall; $3,500 subsidized
  •      Second year-$10,500 overall; $4,500 subsidized
  •      Third year and up-$12,500 overall; $5,500 subsidized
  •      Total limit-$57,500 overall; $23,000 subsidized

Graduate and professional students (unsubsidized only)

  •    Annual limit-$20,500
  •     Total limit-$138,500 including undergraduate loans

PLUS Loan Limits

There are no specific caps on PLUS loan borrowing. The maximum amount of PLUS loans you can take out is the school’s cost of attendance minus other financial aid you receive. 

Private Student Loan Limits

Private student loan limits vary by lender. Generally, the amount you borrow can’t exceed your school’s total cost of attendance.

For a list of some private student loan lenders and their loan limits, click here.

State Student Loan Limits

Every state is different and has their own designated loan amounts for specific programs.

Student Loan Basics

Now that you know the types of loans available, interest rates and loan limits, here are the basics of student loans, including: typical interest rates, how you apply, how you get your money, how you repay, and what happens if you don’t repay.

Student loan interest rates

Federal loans

Both subsidized and unsubsidized loans have a fixed interest rate of 4.99% when disbursed after July 1, 2022 and before July 1, 2023 (although subsidized loans don’t start to accrue interest until after a student is no longer enrolled at least part time).

The Parent PLUS loan has a fixed interest rate of 7.54% when disbursed after July 1, 2022 and before July 1, 2023.

New interest rates for federal loans are typically announced in June of each year.

State loans

States usually offer low interest rates that are fixed by each individual state and program.

Private loans

Private loans are available with both fixed and variable rates. Even though variable rates may be lower, they can change over time which makes it difficult to calculate future payments and interest. Some private lenders may offer forbearance or deferment options, but it’s rare. It’s wise to shop and compare rates before settling on a lender.

How Do You Apply For a Student Loan?

Applying for a federal student loan is easy—complete the FAFSA. All students who submit a FAFSA are eligible for Federal Direct student loans, regardless of financial need or income level.

Because the school can only determine the cost of attendance for one year at a time, you’ll need to submit a new loan application at the start of each academic year. 

When your student receives their Financial Aid Award package, the college will let you know if they qualify for subsidized and/or unsubsidized loans, listing amounts for each. You are then required to accept or reject the loan offers by following instructions from the financial aid office. Be sure to complete all paperwork and/or forms by the required deadline to receive the loan disbursement.

To apply for a PLUS loan, you must first complete the FAFSA. All parents are eligible to apply for a PLUS loan and most are approved. Once you have your FSA ID, sign on to the StudentLoans.gov website and follow the directions for the PLUS loan. Once you receive approval, complete the required forms and paperwork to have the funds released to the college.

To apply for a state loan, parents and students can do a search for each state’s department of post-secondary education by using the contact information on the U.S. Department of Education’s list of state higher education agencies and following the guidelines outlined on each state’s loan program.

If you’re applying for a private student loan, the application process will be determined by the lender. Before applying, you must know the cost of the school, along with the financial aid awarded. Even though the school may send a list of preferred lenders, always do your own comparison before borrowing. Use the Road2College Loan Calculator to compare up to five loans at once. Once approved, the lender will provide loan documents with the interest rates, repayment terms, and other costs associated with the loan.

How Do You Get Your Money?

Entrance Counseling is required before you can receive your first Federal Direct Subsidized or Unsubsidized Loan as an undergraduate, or your first Direct PLUS Loan as a graduate/professional student. You can find this online and complete it in about 30 minutes.

Once your federal loan is ready to be disbursed, the Department of Education will send it directly to your college. They will then apply that money to cover tuition and any other fees. If there is money left over, you will receive it to cover living expenses for the semester. In most cases, your student will receive the money before classes start; but first-time borrowers may have a 30-day waiting period after enrollment. The funds are typically disbursed twice at year—one payment per semester.

State loans are disbursed based on the guidelines specified for each individual state. Once you have applied and been approved, contact the state lender for accurate disbursement information.

When it comes to disbursement of private student loans, each lender sets its own policy.  Some lenders pay the borrower directly. In this case, the student is responsible for paying the tuition bill with the loan disbursement and will oversee handling the remaining funds, if any, to cover living expenses. Other lenders will disburse the loan directly to the college after getting confirmation of enrollment and cost of attendance.

How Do You Repay a Loan?

After graduation, dropping below half-time enrollment, or leaving school, your federal student loans go into repayment.

In most cases, you have a six-month grace period before you must start making payments. PLUS loans typically do NOT have a grace period; payments begin as soon as the loan is disbursed.

Once your loan enters repayment, the loan servicer will automatically start you on a standard repayment plan, which you can request to change if it doesn’t fit your financial needs.

Thankfully, most private lenders realize that students can’t repay loans while they’re still in school and follow the same repayment rules as federal loans.

However, some lenders still do require in-school payments. Always make sure you read your loan documents carefully and any correspondence from your lender after leaving school.

According to StudentAid.gov, “The U.S. Department of Education (ED) uses several loan servicers to handle the billing and other services on loans for the William D. Ford Federal Direct Loan (Direct Loan) Program and for loans that were made under the Federal Family Education Loan (FFEL) Program the ED later purchased. Your loan servicer will set you up under the Standard Repayment Plan unless you tell your loan servicer you want a different repayment plan.”

Your loan servicer will also provide a billing statement with your repayment schedule, payment due dates, number of payments, frequency, and the payment amount. If you choose to have your payments electronically deducted, you will usually receive an interest rate deduction. With federal loans it’s .25%.

What Happens if You Don’t Repay Your Student Loans?

First of all, if you can’t repay, don’t panic, you have options. The worst thing you can do is ignore the situation you’re in. 

If it’s a short-term financial problem and you have federal student loans, you might qualify for a deferment or a forbearance. With private student loans, you have less options and they usually involve refinancing to lower payments.

If you don’t repay your student loans, you can expect these outcomes:

The government will get their money—If it’s a federal loan, the government will eventually (after nine months of non-payment) start taking your money. According to Heather Jarvis, a student loan attorney, “The federal government has extraordinary collection powers. They can garnish wages without a court order, seize tax refunds, intercept other federal benefits, including social security within limits, and prevent borrowers from accessing additional financial aid to return to school.” Even bankruptcy won’t help because federal student loans are not dischargeable.

You can be sued—If it’s a private lender, they will sue you to start the collection process. They will hire a collection agency to pursue you and their tactics are usually aggressive. You can expect phone calls, emails, and letters in the mail. Unlike federal loans, they don’t allow you to miss payments for very long. “Private student loans have many default triggers, typically including just one late payment,” Jarvis says.

Your credit score will suffer—Not paying your student loan will negatively affect your credit score.

The lower your score, the more you pay for a mortgage, a car payment, insurance, loans, cell phone plans, and credit cards. Not to mention, it could affect your future job prospects since many employers check their applicant’s credit score before hiring.

If you can’t make your payment, contact your lender. Try to negotiate or ask for a grace period.

Ask to set up a realistic payment plan or chose some repayment options that fit your financial situation. Again, ignoring the problem will only make it worse.

Student Loan Repayment Options

There are eight different federal student loan repayment plans that you can choose from. If you don’t choose a repayment plan, your loan servicer will place you on the Standard Repayment Plan.

  • Standard Repayment Plan—Features fixed payments made for no more than 10 years with the shortest repayment period.
  • Graduated Repayment Plan—Features lower initial payments that increase every two years. The repayment period is typically no more than 10 years.
  •  Extended Repayment Plan—You must have more than $30,000 in outstanding loans; it allows you to extend the repayment period for up to 25 years. Monthly payments may be fixed or graduated.
  • Revised Pay As You Earn Repayment Plan (REPAYE)—The plan sets your monthly payment at 10% of your “discretionary” monthly income for 20 or 25 years.
  • Pay As You Earn Repayment Plan (PAYE) You must have a high debt relative to your income. The plan sets your monthly payment at 10% of your monthly “discretionary” income, but never more than the monthly payment you would make under the Standard Repayment Plan.
  •  Income-Based Repayment Plan (IBR)—Under this plan, your monthly payments will be either 10 or 15 percent of discretionary income (depending on when you received your first loans), but never more than you would have paid under the 10-year Standard Repayment Plan.
  • Income-Contingent Repayment Plan (ICR)—This plan sets your monthly payment as the lesser of 20% of your “discretionary” income or what you’d pay under a repayment plan with a fixed payment over 12 years.
  • Income-Sensitive Repayment Plan—Available to low-income borrowers with a repayment period of 10 years. The monthly payment is determined based on your annual income.
  • For a more complete explanation of each payment plan and its guidelines, visit StudentAid.gov.

For an in-depth explanation of the pros and cons of each, read A Guide to Federal Student Loan Repayment Plans.

If you borrow from your state educational funding, they will set the repayment plans and options.

If you borrow money from a private lender, the most common repayment plan on private student loans involves a level payment for a fixed number of years depending on the amount of debt.

Some lenders offer the option of extended repayment terms of up to 30 years and/or the option of interest-only payments during the first year or two of repayment, with full principal and interest payments commencing after the interest-only payment period.

Make sure you fully understand your lender’s repayment options before receiving private student loan funds.

Follow this link to access our Loan Payment Calculator.

Are Student Loans Worth It?

According to Forbes: In a 2019 national poll by Morning Consult, 61% of adults said that, even based on their current financial situation, taking out student loans was worth attending college. More than twice as many said loans were definitely worth it (35%) as said they definitely were not (16%).

If you decide to pursue loans, it’s important to borrow wisely and be prepared for the impact of those loans on entry-level incomes.

Use loans to supplement aid from other sources such as scholarships, savings and grants. The key is to borrow only what you need and can repay.

Experts agree that a good rule of thumb for total undergraduate borrowing is to limit your loans to what you expert to earn your first year after graduation. The student loan payment should be limited to 8-10 percent of the gross monthly income.

It’s also important to ask yourself if the money you borrow is worth its return on investment (ROI). For example: Incurring $200,000 in debt for a career that pays $40,000 a year would not be considered a good ROI.

If you aren’t sure of the starting salary for a particular career, check the Bureau of Labor Statistics Occupational Outlook Handbook. On the site you’ll also find information and statistics related to growth potential in various careers, and projections for future hiring needs in those careers.

If you need loans beyond the federal student loans, check out and compare these lenders:

LenderCo-Signer ReleaseRepayment OptionsTermInterest Rates
Yes- Flat Payment (In-School)
- Full (principal & interest)
- Deferred
- Interest-only
5, 8, 10, 15 years4.41% - 16.99% (Fixed)
5.49% - 16.99% (Variable)
Check Rate
Yes- Deferred
- $25 Minimum Amount
- In-School Interest Only
5, 7, 10, 12, 15 years4.48% - 15.66% (Fixed)
6.03% - 15.94% (Variable)
Check Rate
Yes- Pay now or late: Make interest payments
- Pay a fixed $25 payment
- Defer payments until after school
10-15 years4.50% - 15.49% (Fixed)
6.37% - 16.70% (Variable)
Check Rate
SofiYes- Immediate repayment
- Interest-only
- Fixed monthly payments in school
- Fully deferred
5, 7, 10, 15 years4.44% – 14.70% (Fixed)
5.99% – 13.97% (Variable)
Check Rate
Yes- Full payments (Principal and Interest)5, 10, 15 yearsAs low as 4.39% (Fixed)
As low as 6.06% (Variable)
Check Rate
- Deferred
- $25 Minimum Amount
- In-School Interest Only
5, 7, 10, 12, 15 years9.63% - 15.66% (Fixed)
9.92% - 15.94% (Variable)
Check Rate






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