How Do Student Loans Work? An Easy-to-Understand Guide

There’s been a lot of talks lately about student loans and student loan forgiveness programs. To be clear, this is not a political article at all. However, no matter what actions the government takes (or doesn’t take) when it comes to student loan debt, it’s important to understand the basics of how these loans work.

Think about it: most first-time borrowers are between the ages of 17 and 19.

This means that most college students aren’t old enough to buy alcohol or rent a car, yet they’re able to borrow tens of thousands of dollars to finance higher education. In fact, the average student loan debt currently sits at $32,731.

Scary, right? Especially if you don’t know exactly what you’re getting yourself into…

From interest rates to cosigners and deferments to forgiveness, this article covers the basics of what you need to know about student loans. So, let’s get started!

What Are Student Loans?

Student loans are different from other types of loans in that the money is meant to be used specifically for your education. Whether you take out a student loan from the federal government or a private lender, there are certain “school-certified” educational expenses. 

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In other words, you can use a student loan to pay for:

• College tuition and fees
• Room and board
• Institutional fees
• Books and supplies
• Personal living expenses (for dorm room or off-campus apartment)
• Equipment such as laptops, software, and items specific to your major
• Daycare
• Transportation
• Study abroad costs
• And other school-documented costs

Student loans cannot and should not be used for personal leisure expenses such as entertainment, gym memberships, personal travel (vacations), and dining out.

In fact, if you take out a federal student loan and use it to pay for non-education-related expenses, you could potentially be charged with perjury. While it’s unlikely that your lender will track every single cent and how it's spent, there are serious consequences for misuse.

It is also important to note that student loans are different from scholarships and grants. If you are awarded a scholarship or grant, that is money that is freely given to you for higher education. You do not have to pay that back.

Student loans, on the other hand, need to be repaid with interest.

While much of the discussion around student loans can be “negative,” remember that they make college possible for most people. When used appropriately, student loans increase your opportunities! It’s just important that you know how they work to make sure you take out a loan with favorable terms.

What’s the Difference Between Federal and Private Student Loans?

Federal student loans are backed by the United States government. Because of this, they have fixed interest rates and have several unique benefits such as income-based repayment plans and student loan forgiveness programs.

Private student loans are issued by private lenders. Since private businesses are taking a risk by lending you money, these types of loans require credit checks and verifiable income. It’s not uncommon for private lenders to have a set of requirements that are specific to their organization.

In order to get a federal student loan, you have to apply for FAFSA, which stands for the Free Application for Federal Student Aid. You can do this at FAFSA.gov. 

The results of your FAFSA application will be sent to your school(s) of choice. The school will then crunch the numbers and offer you financial aid. 

NOTE: This aid may come in the form of “free” money that is awarded to you such as scholarships and grants. The award letter will also tell you what type of federal student loans you qualify for. 

The different types of federal student loans include:

• Direct subsidized loans. These federal loans are reserved for students who demonstrate financial need based on the results of their FAFSA application. The loans are “subsidized” because the federal government pays the interest rate on the loans while you’re still in school. Once you graduate (or drop below half-time enrollment), you have a 6 month grace period before you have to start repaying the loan and its interest. The interest won’t kick in for you until that grace period is over.
  

• Direct unsubsidized loans. If you don’t demonstrate financial aid, then you can take out an unsubsidized loan. This means that the government will not cover the interest for you. The moment the school receives the loan to pay for your education, the interest will begin accruing and you will be responsible for paying it. Yes, you still have the 6 month grace period before repayment begins, but the interest is all your responsibility.
  
• Direct plus loans. What makes these types of student loans different is that they are taken out by parents, not the students themselves. Since parents take these loans out on behalf of their “dependent” (tax status) students, this requires a separate FAFSA and credit check for the parent taking out the loan.

The biggest difference between federal and private student loans is that private loans tend to be more expensive because of higher interest rates. Another major difference is that monthly payments for private loans can begin while you’re in school. It’s impossible to list all the various terms and conditions because each private lender sets its own terms. Furthermore, you are responsible for all payments and accrued interest, as the government doesn’t subsidize private loans.

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How Much Money Can I Borrow in Student Loans?

No matter where you choose to go to college and how much it costs, there are certain limits to how much you can borrow. 

For undergraduate federal student loans, you are limited to $5,500 to $7,500 per year if you are dependent on your parents. If you are considered independent, then you can borrow $9,500 to $12,500 per year. The exact amount you are eligible to borrow is determined by your year in school.

When it comes to graduate federal student loans, you can borrow up to $20,500 per year. Those in medical school can borrow up to $40,500 per year.

And finally, when it comes to private loans, the maximum amount you can borrow is based on your unique circumstances. A general rule of thumb is to take your college tuition and subtract any financial aid (scholarships and grants) that you are receiving. Broadly speaking, the end total will be the maximum amount that a private lender will allow you to borrow. 

How Does Student Loan Interest Work?

Regardless of which type of loan you take out, the interest begins the moment the loan is disbursed.

The difference is that the federal government will cover the interest for subsidized loans while you’re in school, whereas unsubsidized loans (which includes private loans) require the borrower to be responsible for all of the interest.

Your student loan payment will be the same each month. However, interest is paid before the rest of your payment is applied to the principal balance, which is the actual amount you borrowed. This means that your first payments will be very interest-heavy. In other words, most of your payment will be applied to interest, but as your principal slowly drops, the interest paid will get lower and lower. As the monthly interest declines, you will begin accelerating your principal payments. 

For example, let’s say your monthly student loan payment is $193. This is the average monthly payment for a borrower who owes $20,000. Assuming a 3% interest rate and a 10-year fixed-interest repayment plan, this means that every month, you’ll be paying $193. During your first month, $48 would be going towards interest, and the remaining $145 goes towards the principal balance. Nearly 25% of your payment is going towards interest! Fortunately, the ratio going towards interest will eventually decrease, and the amount going towards your principal will increase!

If you can afford to pay more than the minimum payment, make sure that any extra money is going towards your principal balance. This will help lower your interest, as there is less of a principal balance to charge interest on. In some cases, extra payments are applied to future payments rather than the principal balance, so be sure to designate your additional payments appropriately. 

Final Thoughts

Student loans help you expand your horizon and opportunities by paying for higher education. However, it’s important that you have a plan and understand the ins and outs of student loans.

Every student’s journey is different, so it’s important to have a plan and clear vision for the future. By having a plan, you can determine what makes the most sense for your situation and pay for college in a way that gives you the highest probability for success.

Do you have more questions about student loans?

Do you want tips and advice from people who have been there before?

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