How do student loans work?

Student loans are a source of financial aid for education. They have a low interest rate and a long repayment period, making them ideal for young borrowers.

Zack Sigel 1600

Zack Sigel

Published May 10, 2019

Student loans can help you pay for college. As a source of financial aid, they’ll cover everything from tuition to housing to fees associated with taking classes. Student loans may cover all or part of your educational expenses and can be supplemented with other types of financial aid, like scholarships and grants.

However, unlike scholarships and grants, student loans must be paid back, with interest. Failing to pay back your student loans could damage your credit and result in hefty fines, and even wage garnishment.

There are two types of student loans: federal student loans, which are issued by the U.S. Department of Education, and private student loans, which are issued by private companies. Federal student loans tend to have lower interest rates and more generous repayment terms than private loans.

For loans taken out by the borrower, current federal student loan interest rates are between 5.05% and 7.6%; these rates are set to go down for new borrowers starting July 1, 2019. Private student loans usually have higher interest rates, and, unlike federal student loans, you may have to start paying that interest while you’re still a student.

In this article:

Types of student loans

There are three types of federal student loans: The Direct Subsidized Loan, the Direct Unsubsidized Loan, and the Direct PLUS Loan.

These have low, fixed interest rates and the possibility for deferment and even full discharge, which means you may be able to delay payment or even cancel the loan outright because of certain personal circumstances. Federal loans are the best choice for most people.

Depending on your eligibility, you may be able to take out multiple types of federal student loans.

Direct Subsidized Loan

The Direct Subsidized Loan is a federal student loan offered to students based on their financial need. They are only available for undergraduate students.

The U.S. government subsidizes the loan, meaning that it pays the interest the borrower would otherwise owe while the borrower is in school (enrolled at least half time), if the loan is deferred, and during the six-month grace period after the borrower graduates.

Direct Subsidized Loans currently have an interest rate of 5.05%. Starting July 1, 2019, the interest rate on Direct Subsidized Loans will drop to 4.53% for loans issued after that date.

Direct Unsubsidized Loan

The Direct Unsubsidized Loan is a federal student loan, offered to both undergraduate and graduate students regardless of financial need. Unlike the subsidized version of the loan, the U.S. government does not pay your interest at any point.

While you’re in school, and during the six-month grace period after, interest will accrue to the loan. You can choose to pay the accrued interest during that time, or let it become capitalized — added to the loan balance. Capitalization means you’ll have to pay even more once you start making payments, since you’re essentially paying interest on interest.

For undergraduates, Direct Unsubsidized Loans also have an interest rate of 5.05%, dropping to 4.53% for new borrowers on July 1, 2019.

But for people getting a graduate or professional degree, Direct Unsubsidized Loans have an interest rate of 6.6%, which is set to drop to 6.08% on July 1, 2019, for new loans.

Direct PLUS Loan

The Direct PLUS Loan is also a federal student loan, but it’s only offered students in a graduate or professional school program, and for parents to take out on behalf of their undergraduate dependents. The PLUS Loan is also unsubsidized, so interest will start accruing before you’re required to pay it off.

As with the other federal loans, the Direct PLUS Loan has a six-month grace period. But its interest rate of 7.6% is the highest among federal student loans, although Direct PLUS Loans issued after July 1, 2019, will have an interest rate of 7.08%.

Discontinued federal student loans

The federal student loan program has undergone several changes in recent years. Prior to these changes, student loans were mostly private loans backed by the Federal Family Education Loan Program (FFEL). The FFEL program was canceled in 2010 so that federal student loans could be offered directly to borrowers.

The Federal Perkins Loan was a direct, subsidized student loan for students demonstrating financial need. It was canceled in 2017. Perkins loans had a fixed interest rate of 5%, a maximum loan limit of $5,500, and a nine-month grace period after graduation.

Although no new Perkins loans have been issued, if you’re currently in school and have a Perkins loan, you’ll still have to pay it off when you graduate. But you’ll still benefit from its nine-month grace period.

Private student loans

Private student loans are offered by companies. As such, they are not subsidized and interest will begin accruing to them while you’re in school.

There are numerous options for private student loans. While private student loans may have higher interest rates and less favorable terms and conditions, they may be an important part of your financial plan if federal student loans don’t cover all your educational expenses.

While some private student loans have fixed-rate interest, many others have variable-rate interest, which means your payments may increase over time.

Private student loan interest rates can be much higher than those of federal student loans. For variable-rate private student loans, the interest rate often starts around 4.5% to 4.9%, but it can increase to as high as 11% to 12.5%. Fixed-rate private student loans typically have interest rates between 6% and 13.5%.

The interest on a private student loan is typically listed as the annual percentage rate (APR), which could include multiple costs besides the interest rate.

(Read our guide to APR.)

Most students do not need private student loans. They’re best for people who need large loan amounts and have limited options. They’re also great for students who are enrolled for less than half time, which would otherwise disqualify those students from federal student loans.

How to apply for student loans

To apply for federal student loans, you have to fill out the Free Application for Federal Student Aid (FAFSA). The FAFSA form asks questions about your family’s income to determine if you qualify for any needs-based federal student financial aid, as well as how much you qualify for.

You’ll receive an award letter from your school detailing which student loans you’re eligible for. The award letter should also list any scholarships and grants you’ve been offered by the school.

To apply for private student loans, research lenders online. You may be able to get a private student loan from your bank or credit union, or you may want to use a lending company. You’ll apply for the student loan directly through the company.

In both cases, you may have to fill out the following info:

  • Information about you, including your address and Social Security number
  • Information about your university enrollment, including when you plan to enroll. Private lenders may ask for even more info, like your anticipated degree.
  • Employment and financial information (or that of your parents if you’re a dependent)

For private student loans, the lender may perform a credit check on the borrower, so the borrower may need a co-signer if he or she has no credit yet. For young students and other dependents, the co-signer is usually a parent or guardian.

Co-signers assume all the same responsibility as the borrower. If payments are missed, then the co-signer’s credit will also be affected, in addition to the other consequences.

However, most federal student loans don’t require a co-signer, because federal loans usually don’t require you to have credit.

How to pay off student loans

Your student loan is comprised of three components: the principal, which is the amount you originally borrowed; interest, which is the amount you have to pay to the lender in return for extending you the loan; and fees, such as late fees or origination fees, if applicable.

To pay your student loan, log into your account at your loan servicer’s website. For federal student loans, you’ll have to figure out which third-party company handles your billing; your school’s financial aid office should know.

Private student loans must be paid directly to the lender, either online or through the lender’s mobile app, if one is offered.

Student loans may have different servicers and due dates, so make sure you make payments to each of the respective lenders by their respective deadlines.

You can also mail your payment via check or money order. Make sure to include your remittance slip, which should be attached to your billing statement, and that the address is correct.

Repayment plans

For federal student loans, the following repayment options may be available to you. These can help you make payments according to your financial situation either by matching your payment to your income level or to a specific timeframe.

  • Standard repayment plan: Fixed payment amounts for up to 10 years, which could help you save on interest.
  • Graduated repayment plan: Low payments that get gradually higher for up to 10 years, which could result in you paying more interest.
  • Extended repayment plan: Low payments over 25 years, but you’ll pay more for interest than the standard or graduated plans.
  • Pay As You Earn (PAYE) plan: Payments limited to 10% of your discretionary income, with the outstanding loan balance forgiven after 20 years. To be eligible, you must be unable to afford repayment under the standard plan.
  • Revised Pay As You Earn (REPAYE): Payments limited to 10% of your discretionary income, with the outstanding loan balance forgiven after 20 or 25 years. Unlike the PAYE plan, any borrower may be eligible.
  • Income-based repayment (IBR) plan: Payments based on your income level and limited to 10% to 15% of your discretionary income, with the outstanding loan balance forgiven after 20 or 25 years.
  • Income-contingent repayment (ICR) plan: Payments recalculated every year based on your income and family size, with forgiveness after 25 years. Payments will be the lesser of either 20% of your discretionary income, or the amount you’d pay, adjusted per your income, on a fixed-payment plan over 12 years.

For private student loans, most of these repayment plans will be unavailable. However, you may have the following options, depending on your loan servicer:

  • Fixed repayment: Fixed amounts every month, starting while you’re in school.
  • Interest repayment: Interest-only payments every month while you’re in school, then principal plus interest payments after you graduate. This could result in paying more interest over time, since your principal balance won’t be decreased until you start making payments against it.
  • Graduated repayment: Interest-only payments every month while you’re in school and for one year after, after which you will pay the full amount. This will result in you making higher payments once the interest-only period ends.

Deferment and forbearance

Whether you have a federal student loan or a private one, you may be eligible for deferment or forbearance. These allow you to temporarily stop making payments while you’re experiencing certain personal circumstances, such as financial hardship, or if you’re still in school.

For federal student loans, military service and joining the Peace Corps can also make you eligible for forbearance or deferment.

Note that depending on the terms of your loan servicer, interest may still accrue while you’re in deferment or forbearance.

Forgiveness, cancellation, deferment, and discharge

In many cases, you may be eligible to stop paying your student loans entirely, at no consequence to you. The type of forgiveness or discharge will depend on your specific circumstances as well as the type of loan you have.

Federal student loans

Federal student loans have very generous forgiveness options: If you perform certain types of public service for a period of years, then at the end of that period, your federal student loans will be forgiven.

The Public Service Loan Forgiveness Program (PSLF) covers people who work for government or not-for-profit organizations, join the military or Peace Corps, or work in some other public agency for such as for health and law. Teachers may also qualify for student loan forgiveness.

Your federal student loan may also be discharged (canceled) if you suffer a total and permanent disability or if your school closes down before you finish your degree. Your death will also result in the discharge of your loan.

Private student loans

Forgiveness and discharge options are more limited for private student loans. While forbearance and deferment may be available if you suffer financial hardship, in general, the only eligible reasons to discharge a private student loan is the death or permanent disability of the borrower.

Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.

This post contains references to products or services from one or more of Policygenius' advertisers or partners. While these codes earn us a small fee at no additional cost to you, they do not influence editorial content and we only refer products we love.