How Student Loans Work and How to Use Them


These days, a majority of people who go to college borrow money to pay for school. About two-thirds of college seniors who graduated in 2018 had student loan debt, according to The Institute for College Access and Success. And Americans owe an average of $35,359 in student loan debt, based on data from Experian and the College Board.

Given the rising cost of college tuition, it’s no surprise that students are increasingly relying on loans to help pay for school. Of course, you should explore free sources of college funding first, such as grants and scholarships.

But if you expect to borrow money to pay for a higher education for your children or yourself, here’s what you need to know about the types of student loans that are available and the options for repaying those loans.

Types of student loans

There are two main types of loans for higher education: federal loans and private loans.

As the name suggests, federal loans are funded by the federal government, and the terms of the loans are set by law. You must fill out the Free Application for Federal Student Aid to apply for federal loans, which include the following:

  • Direct Subsidized Loans: The loans, also called Stafford Subsidized Loans, are available to undergraduate students. The government pays the interest on these loans while you’re in school at least part-time and for the first six months after you leave school.
  • Direct Unsubsidized Loans: These loans, also known as Stafford Unsubsidized Loans, are available to undergraduate and graduate students. The government doesn’t pay any of the interest on these loans. 
  • PLUS Loans: These loans are available for graduate students and parents of undergraduate students.

The total amount that undergraduate students can borrow per year in subsidized and unsubsidized federal loans ranges from $5,500 to $12,500, depending on their year in school and dependency status. There aren’t limits on unsubsidized loans for graduate students. The maximum you can borrow with a PLUS loan is equal to the cost of attendance minus any other financial assistance you get. 

Private loans are made by banks, credit unions and other lenders.  The terms and conditions of private loans are set by the lenders – so they will vary from lender to lender.

The difference between federal and private student loans

The key differences between federal loans and private loans are the cost, eligibility requirements and repayment terms, says Mark Kantrowitz, publisher and vice president of research at SavingforCollege.com. In short, federal loans tend to be cheaper, are easier to qualify for and have more flexible repayment terms than private loans, he says.

That’s why you may want to borrow federal student loans first. “If you’ve exhausted your eligibility for federal loans, then you should consider private or parent loans with the caveat that it’s a sign that you’re borrowing too much,” Kantrowitz says.

Federal and private student loans also may differ on whether they are forgiven if the borrower passes away. Federal student loans are dischargeable at death, but roughly half of private student loans programs do not offer death discharges.

Cost of federal versus private student loans

Federal loans have interest rates that are fixed for the life of the loans. Currently, the rate on subsidized and unsubsidized loans for undergraduates is 4.53%, the rate for unsubsidized graduate student loans is 6.08%, according to the U.S. Department of Education. And the rate on PLUS loans is 7.08%.

Private loans can have variable or fixed interest rates that are set by lenders. Currently, private student loan rates range from 3.7% to more than 14%, according to student loan comparison website Edvisors. Variable interest rates tend to be lower, but the risk is that they can rise over time.

Eligibility requirements of federal versus private student loans

To qualify for a federal loan, you or your child must be enrolled at least part-time in an eligible school. The federal government doesn’t check your credit if you’re an undergraduate applying for a student loan. It will look at credit history for PLUS loans for graduate students and parents. But it’s only looking to ensure that you don’t have an adverse credit history – such as a bankruptcy, foreclosure, tax lien or serious delinquency on a debt, Kantrowitz says.

Private loan lenders will check the credit of applicants. Because most undergraduate students have little to no credit history, 90% of private loans for undergraduates require a creditworthy cosigner, Kantrowitz says.

Lenders will look at your or your cosigner’s credit score, income, debt-to-income ratio and other factors to determine whether to give you a loan and at what interest rate. If you need a cosigner to get a private loan, you can protect your cosigner through a term life insurance policy to pay off the loan if you pass away.

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Repayment options for federal loans

When you borrow federal student loans, the standard repayment plan is 10 years, says Andrew Pentis, a personal finance expert and certified student loan counselor with Student Loan Hero. However, the federal government offers seven other repayment plan options that can help borrowers who are struggling to make monthly loan payments. 

Five of those options are income-driven repayment plans that cap monthly payments at 10% to 20% of the borrower’s discretionary income and have repayment periods longer than 10 years. There’s also an extended repayment plan that allows payments to be made over a 25-year period. Although monthly payments will be smaller with these plans, borrowers will end up paying more in interest because of the extended repayment periods.

If you don’t like the idea of racking up higher interest costs, there is a graduated repayment plan that allows you to make smaller payments at first then higher ones to pay off your loan in 10 years.  Pentis recommends using the U.S. Department of Education’s Repayment Estimator tool to figure out which repayment plan is best for you.

If you’re struggling to repay your loans because of a job loss or economic hardship, the federal government offers ways to “press pause on those loans,” Pentis says. You might qualify for a deferment or forbearance. Be aware, though, that interest will continue to accrue on your loans during a forbearance but not with a deferment of certain types of loans.

The federal government also offers loan forgiveness programs for people employed by the government or a nonprofit organization and for teachers working in low-income schools. You have to work a certain number of years in these jobs to qualify.

If you have several federal student loans, you can consolidate them into one loan. That will simplify the payment process. But it won’t save you any money because the new rate will be the weighted average of the loans you’re consolidating rounded up to the nearest one-eighth of a percent, Pentis says. Plus, it resets the clock on your repayment term. So it could take longer to pay off your loans.

Repayment options for private student loans

With private student loans, repayment and debt relief options are limited. “In many cases, private lenders don’t come anywhere close to matching the protection options of federal loans,” Pentis says.

Once you take out a private student loan, it will start accruing interest immediately. You don’t have to start making loan payments while in school, but many lenders encourage borrowers to do so to reduce the amount of interest they have to pay, Pentis says.

Private loan repayment terms typically are 10 to 15 years, Kantrowitz says. A few let you pick the number of years you want for your repayment term. Keep in mind, though, that the longer your repayment term, the more you’ll pay in interest and the higher the cost of the loan will be, Kantrowitz cautions.

If you experience a hardship, some lenders might offer a loan forbearance – typically in three-month increments up to a maximum of 12 months, Pentis says. And most private lenders do not offer income-based repayment plans. If you are struggling to repay a loan, Pentis recommends reaching out to your lender to explore your options.

If you have good credit, you can refinance private student loans and possibly lock in a lower interest rate to save money. You might even be able to qualify for private loan forgiveness or repayment programs available from an employer or from cities and states that offer loan repayment incentives to borrowers who relocate in those areas, Pentis says.

If you need help weighing repayment options, Pentis suggests working with a student loan counselor. You can find free or low-cost counseling through the National Foundation for Credit Counseling.

Cameron Huddleston is the author of Mom and Dad, We Need to Talk: How to Have Essential Conversations With Your Parents About Their Finances. She also is an award-winning journalist who has been writing about personal finance for more than 17 years. You can learn more about her at CameronHuddleston.com. Opinions are those of the author or the person interviewed.

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