how do student loans work

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Let’s talk about student loans.

First, you’re probably wondering what exactly a student loan is. Student loans are a way for you to take out money for school that you don’t have to pay back until after you graduate. They’re also one of the best ways to get yourself through college without racking up debt from high interest rates and fees. But how do they work?

Well, it all starts with your financial aid award letter. You’ll get this in the mail or email from your school, and it’ll tell you how much money they’ve decided to give you for the year. If your financial aid award letter says that there isn’t enough money in the pot to cover all of your costs—like tuition, books and supplies, room and board—then ask them if there’s anything else they can do!

If they say no, then that means it’s time to start thinking about student loans. Student loans are basically just a way for students who need help paying for school to borrow money from banks or other lenders at low interest rates so that they can get by until graduation day without having to worry about whether or not their GPA will be affected by having too much debt hanging over their heads.

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If you need money for college, you might be considering a student loan. But before you apply for one, it’s important to understand how they work.

What is a Student Loan?

If you don’t have the money to pay for college, a student loan will enable you to borrow money and pay it back at a later date, with interest.

College loans are different from a grant or scholarship. If you receive a grant or a scholarship you’re not borrowing that money. That is money that has been given to you as a gift and doesn’t need to be repaid.

What Types of Student Loans are Available?

There are two main types of lenders that offer student loans. The U.S. government offers federal student loans. Banks, credit unions, state loan agencies and other financial institutions offer private student loans.

Be careful, as some of the lenders that offer private student loans also service federal student loans on behalf of the U.S. government, so it is easy to get confused.

Federal loans

Federal student loans are loans that are made by the U.S. government. It’s a good idea to take out federal loans first because these loans are less expensive and usually come with more benefits than loans from private lenders.

The advantages of a federal loan over a private loan include:

  • Fixed and lower interest rates
  • The ability to borrow money without a cosigner
  • Repayment plans that start six months after you leave college or attend less than half time
  • Flexible repayment plans like income-driven repayment and extended repayment
  • There is also the possibility that some of your loans can be forgiven — that is you don’t have to repay them — if you work in certain professions, such as teaching and public service

There are four types of federal student loans for college:

Direct Subsidized Loan

Subsidized Stafford loans are available to undergraduate students with demonstrated financial need. While enrolled in college at least half-time and for six months after you graduate or drop below half-time enrollment, you won’t have to pay interest on the amount you borrowed. This can be a huge cost savings.

Direct Unsubsidized Loan

Unsubsidized Stafford loans are available to undergraduate and graduate students, regardless of financial need. Unlike subsidized loans, you will need to pay the interest that has accrued on your loan while you are in college, or the interest will be capitalized (added to the loan balance).

Federal Direct PLUS loan

Grad PLUS and Parent PLUS loans are available to graduate students and parents of dependent undergraduate students. PLUS loans aren’t subsidized, so interest will start accruing as soon as the loan is fully disbursed. Repayment can be deferred while the student is enrolled in college and for six months after graduation.

Federal Direct Consolidation loan

Consolidation loans allow you to combine multiple federal student loans into one loan, without losing the benefits of the federal loans. Consolidation can be used to streamline repayment or to switch loan servicers.

Private loans

Private student loans are loans that come from a private lender, usually a bank, a credit union, a state loan agency or a non-bank financial institution. They can come with fixed or variable interest rates and often require the student borrower to have a cosigner. Interest isn’t subsidized, so as soon as you borrow money the loan will begin accruing interest.

How Does Interest on a Student Loan Work?

Because you’re not just paying back the amount you borrow, you’re paying back interest as well, it’s important to understand how much that will add to the total amount you pay.

How much you pay in interest depends on a number of factors: whether your loan is subsidized or unsubsidized, the interest rate on your loan, the amount you borrow, and the loan term.

For example, you graduate with a $10,000 loan with a 5% interest rate and plan to pay it off over 10 years. You will pay $2,728 in interest over the 10 years that you repay the loan. Your monthly loan payment will include both payments to reduce the principal balance (the amount borrowed) and interest payments. The total amount repaid will be $12,728 including both principal and interest. 

Interest generally continues to accrue during forbearances and other periods of non-payment. So, if you take a break on repaying your loans or skip a loan payment, the total cost of the loan will increase, and not just because of late fees.

Loan payments are applied to the loan balance in a particular order. First, the payment is applied to late fees and collection charges. Second, the payment is applied to the interest that has accrued since the last payment. Finally, any remaining money is applied to the principal balance. So, if you pay more each month, you will make quicker progress in paying down the debt.

You can use a loan calculator to help you calculate exactly how much you’ll pay in interest.

How to Pay Less Interest

You can reduce the amount you pay in interest by making extra loan payments to pay it off sooner or by refinancing your student loan to a loan with a lower interest rate. However, refinancing federal student loans into a private loan means a loss in many benefits – income-driven repayment options, possible loan forgiveness or widespread forgiveness, generous deferment options, and a death and disability discharge.

How Do You Apply For Student Loans?

The application process for federal student loans and private student loans is different. Remember, you should only apply for a private student loan once you have exhausted your federal student loan options. 

Federal student loan process

To apply for a federal student loan you’ll need to file the Free Application for Federal Student Aid (FAFSA). The information on the FAFSA will determine how much you’ll be able to borrow. Your college will send you a financial aid offer, which will include details on how to accept your loan. You will then need to sign a Master Promissory Note (MPN).

Private student loan process 

To apply for a private loan you don’t need to file a FAFSA. You’ll need to apply for a loan with an individual lender. The lender will check your credit score and will often require a creditworthy cosigner.

how do student loans work for college

A student loan is money borrowed from the government or a private lender in order to pay for college. The loan has to be paid back later, along with interest that builds up over time. The money can usually be used for tuition, room and board, books or other fees. But some students use their loan money for other stuff—like trips to Jamaica for spring break.

Ready to get rid of your student loans once and for all? Get our guide.

Let’s be clear: Student loans are different from scholarships and grants. Loans always have to be paid back (unless you’re one of the lucky few who gets part of your loan forgiven, but that’s pretty rare). Scholarships and grants, on the other hand, don’t need to be paid back (everyone loves free money, right?). Student loans are also different from work-study programs, where students get paid to work on campus.

Parent PLUS Loans: What You Need to Know | Student Loans and Advice | US  News

how do student loans work for parents

The standard repayment term on a parent PLUS loan is 10 years of fixed payments. Parents may also request a 10-year graduated repayment schedule, which starts with smaller monthly payments and increases the payment amount every two years until the loan is paid off. Parents who borrow $30,000 or more in PLUS loans can opt for an extended 30-year repayment schedule.

You have the option to begin making payments on a PLUS loan as soon as the funds are issued or waiting for up to three years after the student’s graduation to begin paying back the loan. Interest accrues on the loan starting on the day the funds are issued, however, so deferring the start of payments, using graduated payments and extending the repayment period all increase the overall cost of the loan.

In addition to the interest charges associated with your loan, parent PLUS loans carry an origination fee, calculated as a percentage of the total loan amount. The current fee percentage is just under 4.25%. This sum is commonly rolled into the monthly loan payment schedule. Using the fee and interest rates currently in effect, that means you’ll be charged 7.6% interest on 104.25% of the amount you borrow, starting the day the loan is issued.

If it turns out that you don’t end up needing or using the full amount of a parent PLUS loan, and under certain other extreme circumstances, there are provisions for cancelling some or all of a parent PLUS loan.

Student Loan Guide: ​10 Things Parents & Students Need to Know Before  Taking Out Student Loans | Money | 30Seconds Mom

how do student loans work reddit

We know you’re probably wondering when your payments are going to be restarted.

We’re sorry to say that we don’t have an answer for you right now. We’re doing everything we can to get this program back on its feet, but the truth is that it’s not likely to happen any time soon. With gas prices at record levels and inflation out of control, Congress would have a hard time justifying restarting payments right now.

Now don’t get us wrong—we know your situation isn’t great right now, and we want to help as much as possible. But it just doesn’t seem like restarting payments would be a good idea at this point in time.

how do student loans work usa

Here’s the thing about student loans: Not enough students understand how they really work or the effect they can have on future goals and plans. When you’re about to graduate from high school, it can feel like everyone wants you to continue your education, but nobody can tell you the best way to pay for it. It’s just kind of expected that if you want to go to college, you’re going to have to take out a massive loan (or two) in order to afford that diploma.

And that’s why we have a $1.6 trillion student loan crisis in our country right now.1  But here’s the deal: I’ll tell you everything you need to know about student loans if you promise not to take them out. Deal? Deal.

What Is a Student Loan?

A student loan is money borrowed from the government or a private lender in order to pay for college. The loan has to be paid back later, along with interest that builds up over time. The money can usually be used for tuition, room and board, books or other fees. But some students use their loan money for other stuff—like trips to Jamaica for spring break.Bullseye icon

Ready to get rid of your student loans once and for all? Get our guide.

Let’s be clear: Student loans are different from scholarships and grants. Loans always have to be paid back (unless you’re one of the lucky few who gets part of your loan forgiven, but that’s pretty rare). Scholarships and grants, on the other hand, don’t need to be paid back (everyone loves free money, right?). Student loans are also different from work-study programs, where students get paid to work on campus.

How Do Student Loans Work?

People get federal student loans by filling out the Free Application for Federal Student Aid (FAFSA). Students and their parents share their financial information on the form, which is then sent to the student’s schools of choice. The financial aid office at each school crunches some numbers to figure out how much (if any) aid the student qualifies for and then sends them an “award letter” with all the details about their financial aid offer.

Note: This aid could come in the form of student loans, or it could come in the form of scholarships and grants. So that’s why I still recommend filling out the FAFSA—just make sure you only accept the free money. This is a no-loan zone, people.

Students apply for private student loans straight from the lender. But for federal loans and private loans, the student has to sign a promissory note (sounds scary, right?). That’s a legal document where the student agrees to repay the loan plus interest, and it includes all the terms and conditions of the loan.2 It’s kind of like signing away your freedom. Kidding, but not really.

Get Updates About Student Loan Payment Relief

Whatever happens with federal student loan relief, we’ll let you know! Whether relief extends or ends, we’ll tell you what the next steps are in paying off your student loans.Enter your email addressGet Updated

Types of Student Loans

There are two main types of student loans: federal and private. They’re both poisonous for your future, but the main difference is that federal loans are issued by the government, while private loans can be issued through a bunch of different sources, like banks, schools, credit unions or state agencies.

Federal Student Loans

• Direct Subsidized Loan: These are undergraduate loans for students who show financial need based on their FAFSA. The government pays the interest until the time comes to start paying the loans back. Once the student leaves school or drops below a certain number of hours, there’s a six-month grace period before repayment starts and interest begins to build up.

• Direct Unsubsidized Loan: These are undergraduate or graduate loans where students don’t have to demonstrate financial need. With unsubsidized loans, the government doesn’t cover the interest—interest starts building up from the minute the school gets the loan money.

• Direct PLUS Loans: These are loans that parents can take out for their dependent students or that graduate students can take out for themselves. These require a separate application from the FAFSA and a credit check.

Private Student Loans

Basically, all you need to know about private student loans is that they’re usually more expensive and have higher interest rates than federal loans, and the student has to start making monthly payments while they’re still in school. It’s up to the lender to decide all of the terms and conditions of the loan. Plus, the student is responsible for all interest payments—there’s no counting on the government for help.

How Does Student Loan Interest Work?

So, interest can be your friend—the good kind of interest that makes your investments grow from a couple of hundred dollar bills to a mountain of cash, that is. But what about when it’s loan interest? That’s a totally different story. The way interest works on a loan means you end up paying way more money than you originally borrowed. It’s the worst.

To figure out your loan interest, you have to understand a few terms. Boring, I know. But stay with me!

Loan Repayment Term: That’s how long you have to pay the loan back. For most federal loans, that’ll be 10 years (but it can take up to 30 years).3 For private loans, the term can vary based on the terms of your loan agreement.

Interest Rate: This is how much interest you’ll be paying on the loan. Federal loan rate percentages can vary per loan, but they’re usually fixed (meaning the interest stays the same every year). Private loans are typically based on your credit rating, so they can vary a lot—and they can be fixed or variable.

Principal: This is the base amount you owe for the loan, not including interest. So, if you took out $35,000 in loans, your principal would be $35,000. (That’s the average amount of debt each student loan borrower will graduate with, by the way!)4

So, here’s the math (everyone’s favorite part): Let’s take that $35,000 principal and say you have a 10-year loan repayment term with a fixed interest rate of 5%. (Typical interest rates can range from 3.73–5.28%, depending on the loan type.)5 With those numbers, your monthly student loan payment would be just over $370, and the total amount of interest you’d pay during the loan term would be almost $9,550. So, you might’ve started out by borrowing $35,000, but in the end you’d really pay about $44,550.

Are y’all feeling sick yet? I am.

Student Loan Repayment Options

If you decide to take out student loans (which I already know you won’t do, because you promised), you also make a decision for your future self—the decision to spend the next 10 or more years of your life making monthly payments. Don’t be a jerk to your future self.

Here’s a quick look at what you could be dealing with.

Repaying Federal Loans

• Standard Repayment Plans: The government or your lender provides a schedule with a set monthly payment amount. For federal loans, the plan is for 10 years. Private loans will vary.

• Graduated Repayment Plans: The payments start off lower, but they increase every couple of years or so. The plan is still to have everything paid off in 10 years.

• Extended Repayment Plans: These plans extend the payments beyond the normal 10-year window for borrowers who have more than $30,000 in outstanding loans. The payments could be fixed or graduated (meaning the payments increase little by little) and are designed to pay off the loan in 25 years.

• Income-Based Repayment Plans: These plans base your payments on a percentage of your income. Usually, you’ll pay between 10–15% of your income after taxes and personal expenses are covered. The payments are recalculated every year and adjusted for things like the size of your family and your current earnings.

• Income-Contingent Repayment Plans: This is similar to the income-based plan, but is based on 20% of your discretionary income (that’s the amount of income you have left after your set expenses are taken care of). The rates are adjusted every year and the balance can be forgiven—and taxed—over time (usually 25 years).

• Income-Sensitive Repayment Plans: These are similar to the other income-related plans, but the payment is based on your total income before taxes and other expenses, instead of your discretionary income. The loan payment is calculated to be paid off in 10 years.

Repaying Private Loans

Since private loans are agreements between you and the lending institution, the lender makes the rules for payment. You’ll pay a set amount each month that’s a combo of a principal payment and interest, and the payments are usually set for a specific amount of time. Any changes in that plan—like a graduated payment schedule—would need to be negotiated with the lender (you could always try bribing them with cookies or something). 

What Happens if You Can’t Afford Your Monthly Payment?

Now listen, you guys: When you take out student loans, you commit to paying back the money. But you might’ve heard about some loan-dodging options that let you take “the easy way out.” Honestly, these options are only temporary, short-term fixes to long-term problems—and sometimes, they can end up costing you more in the long run.

  • Forbearance: Your payment is put on hold, but the loan continues to accumulate interest. There are two types of forbearance: general (where the lender decides your level of need) and mandatory (where the lender has to grant forbearance based on your situation).
  • Deferment: With deferment, you temporarily don’t have to make payments, and you may not be responsible for paying interest on your loan. Not everyone is eligible for deferment or forbearance, but you might qualify if you’re unemployed, serving in the military during wartime, or serving in the Peace Corps.
  • Student Loan Forgiveness: Again, not everyone qualifies for this—there are a whole bunch of different requirements, like working full time in a qualifying public service job while making payments for 10 years, teaching in a low-income school for at least five years, etc. The scary thing is, as of April 2021, less than 1% of applications for student loan forgiveness through public service were actually approved.6 You can’t rely on this stuff, y’all.
  • Default: This is what happens if you keep missing payments. Your loan is referred to as delinquent the day after you miss one payment, and if you continue to miss payments, you go into default. This means you failed to pay back the loan based on what you agreed to when you signed the paperwork, and it can have super serious consequences. You could be taken to court, lose the chance to get other financial aid, or be required to pay the entire balance of your loan right away. Not fun.

Refinancing Student Loans: Refinancing is actually a great option for some people. It can definitely help you get that loan paid off quick! But it’s not a universal solution for everyone. So it’s important to think through your own specific situation before you go with refinancing. There are four things that must be true for it to work:

  1. It should be completely free to refinance. Why buy something you could get without paying a dime?
  2. Only go with a fixed rate. Don’t give your lender the power to pull your rate way up at some random future date.
  3. Go for a shorter loan repayment term than you currently have. We are trying to speed this process up!
  4. Get yourself a lower interest rate. The less interest you can pay the better!

If you can’t say yes to each of those items, refinancing is not your best strategy. But if you find a lender who helps you pay less interest, with no fees, a fixed rate and a quicker payoff date, you’ve got a winner! This is the company I recommend as the best way to get a great deal on student loan refinancing.

How to Avoid Student Loans

Still not convinced that student loans are the worst way to fund your education? What if I told you that roughly 6% of students owe more than $100,000 in student loans (which seriously slows down all financial progress after graduation)?7 According to our own Ramsey Research, 63% of student loan borrowers worry consistently about paying back the money, and 44% of them say they can’t even buy a house because of their student loan debt.

You might be thinking: Okay, Kristina, I get it. Student loans are bad. What’s the alternative?

I like the way you think. And even though the rest of the world makes it seem impossible, you can cash flow your whole college experience with some smart strategies and hard work.

Here are just a few examples of how you go to school without loans:

  1. Find scholarships and grants. You can find free money by filling out the FAFSA form, researching organizations in your field of interest that offer scholarships, and using online scholarship search tools.
  2. Choose a school you can afford. That might mean starting out at community college or going to a public, in-state school instead of a private university (there really is a huge difference in tuition costs). It might mean going to a trade school or vocational school—and that’s totally okay. If you find yourself asking if college is really worth it, remember: The only real “dream school” is the one you can afford to go to debt-free.
  3. Work. Yep, even when you’re in high school. A part-time job or side hustle won’t hurt your grades if you keep it to 20 hours per week or less, and you’ll make bank for your college fund. Once you’re in college, try looking for an on-campus job or work-study program, or apply to be a teaching assistant.
  4. Be smart about your lifestyle. Going to college doesn’t mean you have to live in a fancy dorm room with a $10,000 meal plan. Live at home if you can. Stop eating out with your friends every weekend. Split groceries, rent and utilities with a roommate (or three). Use public transportation or walk whenever possible. Get creative and find other ways to cut down on costs. And this part is crucial: Stick to a budget. That will make all the difference in helping you take control of your money.

You guys, that’s only a small part of the plan you can use to help you go to college debt-free. If you want more practical, real-life tips for cash flowing your education, check out Anthony ONeal’s book Debt-Free Degree!

The decisions you make today will have a lasting impact on the financial stability of your future. When you take these steps now, you set yourself up for a lifetime of success (and freedom from those monthly payments). Now let’s make it happen!

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