How Do Student Loans Work?

As you begin your journey towards obtaining your degree, whether it's a bachelor's or a master's, your first degree or your third, or online or on-campus, you'll quickly discover that determining how you are going to pay for your education is one of the biggest decisions (and challenges) you'll face. While there are a plethora of financial aid options available to students, one of the most common - and the most confusing - is the student loan.

Despite being so widely used, many people don't really understand student loans, which leads to students taking on excessive debt, repaying more each month than they can afford, or missing out on opportunities to secure loans with better terms and interest rates. Because there's so much variability, it's important to have a clear sense of how student loans work before taking on debt.

In this blog post, we're covering some student loan basics to help you make smart decisions when it comes to financing your education, focusing on the difference between federal and private student loans, and how to apply for student loans. Remember, there's a lot of information about student loans we're not covering here, and the best way to understand your options is to have a conversation with your school's financial aid office.

 

Federal vs. Private Student Loans

While you might think that a loan is simply a loan, there are actually two types that vary significantly from one another: federal and private. Chances are, you've heard these terms being used in conversation, but if you're still wondering what the difference between federal and private loans is, we'll break down what each type consists of.

Federal Student Loans

The U.S. Department of Education offers several federal student loan programs, with the Direct Loan Program being the largest and most widely-used. This program offers multiple loan options to students, based on degree level and financial need. Loans are also available to parents of dependent undergraduate students and to those who do not demonstrate financial need.

Federal loans do have limits: undergraduate students can borrow between $5,500 and $12,500 per year in Direct Loans, and graduate students can borrow up to $20,500, depending on a number of factors. There are also lifetime loan limits, which may affect your eligibility depending on how many degrees you have pursued or institutions you have enrolled in.

Federal student loans are a good option for many students, as they offer a way to cover the cost of education at relatively low, fixed interest rates. Additionally, federal student loans typically offer flexibility when it comes to repayment options, making it easier for students to afford their monthly payments through deferral or income-based repayment, and offer subsidization to many students, which means that interest on the loan will be paid for while students are enrolled in school. Interest on student loans is also tax deductible, which is of particular benefit to adult students with full-time employment.

However, it's important to carefully consider how much debt you are comfortable taking on. You will be responsible for paying back the full amount you borrow - so just because you are approved to borrow a certain amount doesn't mean you have to use it all! Many students don't think about how quickly loans can add up, and how significantly they can impact future finances. Do some calculations to determine how much you can afford to repay based on your actual or projected income, and let that number guide you when making your loan-related decisions.

You can learn more about federal loans, including your eligibility for certain programs, on the Federal Student Aid website.

Private Loans

Private student loans, as the name implies, are granted by private lending institutions, such as banks, credit unions, or state agencies. In general, students should only consider private loans as a supplement to federal loans and other financial aid, as private loans are less regulated and tend to cost more to the student over the long term.

Private loans do not come with subsidization programs, as many federal loans do, and typically have significantly higher or variable interest rates, which means that the student could end up paying back far more than they borrowed over the life of the loan. These loans are also not eligible for the repayment plans offered by the government, meaning that, in most cases, you will be responsible for sticking to a fixed repayment schedule from the moment you graduate - and the monthly payment owed is often much higher than students realize. Private student loan interest is also not tax-deductible.

Additionally, whereas federal aid is available to all students regardless of their credit history or income, private lending institutions will almost always need to see an established credit record in order to grant a loan, and your credit score will affect your interest rate. In some cases, you may need a cosigner to help ensure that the loan will be repaid. This presents a significant obstacle to students with poor credit.

However, the reality is that federal loans will usually not cover the full cost of a student's education, and most students will need to find an additional source of aid. While students should try to explore all other options first, if used sparingly, private loans are an important resource to help students meet their educational goals. To make sure you are borrowing from a reliable source and getting the best possible rate, use a trusted loan comparison site, such as Credible, to explore your options.

 

Applying For Student Loans

Anyone who is interested in taking out a student loan, and is wondering how to qualify for student loans, should begin by filling out the FAFSA, or the Federal Application for Federal Student Aid. The FAFSA collects a wide range of information about your income, based on your tax return from two years prior. The application will be used to determine your eligibility for aid, and can be sent to directly to the schools you're applying to.

The application process for private loans will vary depending on the institution, but the information they require will likely consist of much of the same information you'll be providing on the FAFSA.

It is usually recommended that you spend some time using a free online loan calculator to help you clearly understand what your monthly payments will be based on the amount you're planning to take out, and what salary you'll need to be making in order to afford those payments.

Many people are confused about the timing of financial aid, and one of the most frequently asked questions financial aid offices get is, "When do you apply for student loans?" Contrary to what many people think, you should begin the student loan process as early as possible - ideally, even before you submit your applications to the colleges you're interested in. That way, you can have the financial aid and admissions process going at the same time, and when you're accepted, you'll have a better sense of your financial aid status and can make a more informed decision about whether to accept your offer (or whether you'll need to pursue additional funding sources).

 

Other Questions You May Have

Now that you know the types of student loans you can take out, and how to apply for them, you're well-positioned to begin the financial aid process. However, you likely still have other questions about student loans. Some of these might include:

• How does student loan interest work?
• How much will I be required to pay back every month?
• When does interest begin accumulating on my loan?
• When do you pay back student loans?
• What happens if I can't afford my monthly payment?
• How long will it take for me to pay off my loan?
• Are there other financial aid opportunities available that might offset the amount I'll need to borrow in loans?

 

And remember - it's important that you have a conversation with your school's financial aid office to get the answers you need before you commit to a loan.