How Do Student Loans Work?

Student loans help pay for your college expenses, including tuition, room and board, fees, and other education-related expenses. There are two types of student loans available — federal loans and private loans, each with different features and options available to borrowers.

If you’re looking to go to college and need some financial assistance to pay for it, student loans can help you cover the costs. But they aren’t free, and you’ll end up paying them back with interest over a set period of time. So how do student loans work?

We’ll cover the details of how student loans work, the pros and cons of using student loans, the different types of loans available, and how to apply for student loans to help pay for your college costs.

Types of Student Loans

There are two main types of student loans available: federal and private. Government-backed federal student loans offer additional borrower protections, whereas banks, credit unions, and other financial institutions provide private student loans.

Federal loans

Government programs offer federal loans, typically referred to as “direct loans.” You can obtain these student loans by completing the Free Application for Federal Student Aid (FAFSA).

There are several types of federal student loans available and each is subject to different interest rates and loan terms:

Direct subsidized loans: Students qualifying for “financial need” can obtain subsidized loans as undergraduates, where interest does not accrue while in school or during deferment or grace periods. Up to $23,000 in subsidized loans is available for a four-year degree. Subsidized undergraduate loans have a fixed 5.50% APR interest rate.

Direct unsubsidized loans: Undergraduate students who don’t qualify for “financial need” can get unsubsidized loans that accrue interest while in school and during payment deferment and grace periods. Dependent students can access up to $31,000 in unsubsidized loans for a four-year degree, while non-dependent students can borrow up to $57,000. Unsubsidized undergraduate loans have a fixed 7.05% APR interest rate.

Direct PLUS loans: Direct PLUS loans are for graduate students and professionals, while Parent PLUS loans are for parents of students. You can borrow up to $138,500 in total PLUS loans, with no more than $65,500 in subsidized loans. Loan totals include amounts borrowed for undergraduate study. Direct PLUS loans have a fixed 8.05% APR interest rate. 

Direct consolidation loans: You can combine several federal student loans into a Direct consolidation loan. This allows you to extend your payment terms and possibly lower your monthly payment but could result in paying more interest over the life of the loan.

How student loans work: Federal student loans offer

Federal student loans also offer a wide range of borrower protections, including:

Borrower defense loan discharge: If your school participated in any misconduct related to your loans or educational services, you may be eligible to have your loans discharged.

Income-driven repayment: You can apply for an income-driven repayment plan that offers lower payments based on your discretionary income. 

Grace period: Federal loans typically offer a grace period, allowing you to avoid making payments while in school and up to six months after graduation.

Subsidized loans: For certain borrowers, federal student loans may subsidize interest payments on loans while in school and during the grace period.

Paused payments: During a national crisis, the federal government may pause student loan payments and interest accrual.

How student loans work: Private loans

Private student loans are available from banks, credit unions, and other lenders, offering a wide variety of loan terms, rates, and repayment options. In general, the better your credit history and profile, the better rates and terms will be available when applying for private student loans.

While federal loans offer fixed rates and maximum loan amounts, private student loans may offer fixed or variable rates, and some don’t have borrower caps. This makes them a good option for students that need access to larger loan amounts, or those who want more flexible loan choices.

Interest rates on private student loans are competitive with federal loans for borrowers with excellent credit profiles but may have much higher rates for borrowers with a short credit history or poor credit score. Rates vary from around 5% APR to nearly 17% APR. To get lower rates or even qualify for a loan, you may need to apply with a co-signer. This is common among student borrowers who don’t have a steady income or a credit history.

Finally, private student loans lack many of the borrower protections offered by federal student loans. Loan forgiveness, forbearance, income-driven repayment, and payment postponement are not available through most private lenders. This makes private loans more difficult to manage if you run into income issues in the future, and there are very few options for loan forgiveness available.

Related: Federal vs Private Student Loans

How to Apply for Student Loans

To apply for student loans, you’ll need to provide your personal and financial information and are typically subjected to a credit profile review as well.

The process is slightly different for both federal and private student loans.

How student loans work: Federal student loan application

To apply for federal student loans, students and/or parents will need to fill out the Free Application for Financial Student Aid (FAFSA). This application helps determine eligibility for subsidized and unsubsidized loans, and any federal grant programs available. 

Submit the FAFSA form by 11:59 p.m. CT on June 30, 2024, for the 2024 – 2025 school year.

Submit any corrections or updates by 11:59 p.m. CT on Sept. 14, 2024.

After turning in the FAFSA, you can review your loan options and select your loan amounts and terms. If the amount does not cover the full amount of college expenses needed, you may need to look at applying for private student loans as well.

How student loans work: Private student loan application

You can apply for private student loans through a bank that offers loans or an online student loan lender. There are a wide range of online lenders to choose from, and they typically offer the best rates (but only if you have great credit).

Applying for private student loans online requires applying, as well as any supporting documentation required. This may include financial and tax documents but usually does not require a list of your savings accounts, investment accounts, or business assets.

A private lender may offer a “pre-qualification” tool that does a “soft” credit check first and will show you potential rates and loan terms before you have to complete a full application.

What Can Student Loans Be Used?

You can use student loans to cover the costs of college and professional education. This may include:

• School tuition and related fees
• Books
• Room and board (i.e. college dorm rent and utilities)
• Transportation costs (i.e. gas or a bus pass)
• Technology costs
• College meal plans or other food costs

Both federal and private student loans cover these costs, but it's advisable to confirm with your lender what is covered before borrowing.

How Does Student Loan Interest Work?

Student loan interest is a fee that lenders charge to student loan borrowers for access to loan funds. The interest rate is expressed as a percentage of the loan balance, which is charged over one year. This is known as the annual percentage rate, or “APR.”

Interest rates can be fixed — remaining the same over the life of the loan — or variable, which means the interest charged can go up or down, depending on the Federal Funds rate.

Interest begins to accrue on most student loans as soon as you receive the funds. This means that interest is added to your student loan balance if you don’t make any payments while in school.

Due to the absence of mandatory payments during school, your student loan balance can increase significantly before any repayment obligations arise. This is true of private loans and most Federal student loans — subsidized Federal loans are the only type that does NOT accrue interest while in school or during the grace period.

When making payments on your student loans, you pay the interest balance first, followed by the principal balance. Most student loan payment schedules follow an amortized structure, similar to a mortgage, where initial payments primarily cover interest with minimal contributions to the loan principal. Over time, payments shift to pay down more principal, assuming you stick to the payment schedule.

Interest on most student loans accrues daily and is periodically capitalized, adding to your loan balance.
Compounding interest, especially with minimum monthly payments, can lead to significant costs, emphasizing the importance of understanding your repayment strategy. Capitalized interest causes you to pay significantly more than your initial loan balance, contributing to the total repayment amount.

Related: How Student Loan Interest Works

Repaying Student Loans

Student loan repayment terms vary by the type of loan you use, as well as the loan terms chosen. Repayment for both private and federal student loans is required; discharging student loan debt in bankruptcy is not an option. So it’s important to understand your repayment terms before applying.

Payment plans

Private student loans offer a wide range of repayment plans, with varying loan terms and options for monthly payments. Most lenders offer from 5-year to 20-year repayment terms. Your interest rate may vary as well, making your payments adjust over time.

Federal student loans have several repayment plans available, including:

• Graduated repayment: A 10-year repayment schedule where payments start lower and increase over time.
• Extended Repayment: You can extend payments up to 25 years, and any remaining balances may qualify for forgiveness.
• Income-driven repayment: Several plans adjust your payment based on your discretionary income and family size. These plans can extend the length of payments up to 25 years, and any remaining balances may qualify for forgiveness.

Student Loan Forgiveness

Private student loans don’t generally offer any student loan forgiveness options. Because for-profit private lenders offer loans, borrowers must make payments, and the lenders earn money through collected interest.

In rare cases, such as permanent disability or death, the remaining loan balances with a private lender may be discharged. Still, you’ll need to check with your lender to see what options are available in those circumstances.

Federal student loans, on the other hand, offer several student loan forgiveness options. Before applying for student loans, comprehending these options is crucial. It informs your loan and career decisions, potentially saving thousands.

Federal Student loan forgiveness

Federal student loans offer several forgiveness options, including:

• Public Service Loan Forgiveness (PSLF): Employees of certain government agencies and non-profit organizations that make 120 consecutive on-time student loan payments may qualify to have their remaining loans forgiven.
• Teacher Loan Forgiveness (TLF): Public school teachers may be able to apply for up to $17,500 in loan forgiveness (as of 2023). This is only for teachers in a low-income school or educational service agency who have taught there for at least five consecutive years. Teachers may also qualify for PSLF and might receive a higher amount of forgiveness compared to TLF, so review your loans carefully.
• Nurse Corps Loan Repayment (NCLRP): Nurses working in a Critical Shortage Facility (CSF) or eligible nursing school (as faculty) for at least two years may be able to apply for loan forgiveness for up to 85% of their loan balances. This includes registered nurses (RNs), advanced practice registered nurses (APRNs), and nurse faculty (NF).
• Income-Driven Repayment (IDR): Income-Driven Repayment plans offer loan forgiveness for remaining balances after making on-time payments for 20 to 25 years (depending on your loan type). Forgiveness for undergraduate loans occurs after 20 years, while graduate loans become eligible for forgiveness after 25 years.

Related: How to Apply for Student Loan Forgiveness

FAQs

Why do I owe more than I borrowed on my student loans?

Student loans accrue interest even when payment is not required. This interest is periodically added to your loan balance (“capitalized”), which increases your total loan balance. If you have unsubsidized loans and haven’t begun paying them back, your balance will increase until you make payments.

Can I get a student loan without my parents?

Certainly, you can secure a student loan independently, even with limited credit or income history, freeing you from parental involvement. Federal student loans are available to “dependent” students, with some limitations. As of 2023, a four-year degree can borrow up to $31,000, and up to $138,500 for a graduate degree. With a stable income and credit history, you can independently apply for a private student loan, potentially without parental assistance.

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