How Direct Loans Work

Since direct loans are a government program, it probably won't surprise you to know that they involve a lot of paperwork, guidelines and red tape. However, many others have successfully navigated this path before, so there's hope. Here's what you need to keep in mind before you begin your application.

The most important element in your direct loan application is the Free Application for Federal Student Aid (FAFSA). This application will contain all of the pertinent financial information that the Department of Education -- and, sometimes, other lenders -- use to determine what kind of aid is appropriate. You can either fill out the FAFSA electronically or mail in a hard copy. If you're planning to go the electronic route, applying for a PIN -- a four-digit number used to identify you on federal student aid Web sites -- ahead of time will make the process a little smoother.

When filling out the FAFSA, you'll include a code representing each of the schools to which you are applying. Once the application has been processed by the Department of Education, you and the schools will receive a Student Aid Report (SAR) that includes your Expected Family Contribution (EFC). The schools will use all of this information to determine what kind of federal financial aid eligibility you have, and then they'll present you with a financial aid package [source: FAFSA Overview].

Once you've determined which school you'll be attending and negotiated the financial aid package, you'll sign a Master Promissory Note (MPN). The MPN is a binding contract between you and the Department of Education and states that you promise to repay the loan. It also outlines the terms of the loan, penalties for late payments and defaulting, and repayment procedures. The Federal Student Aid Web site has a number of sample MPNs available for viewing. As with the FAFSA, you can fill out the MPN either electronically or in paper format.

So, now you've jumped through the hoops and settled on a financial aid package. But what are the options for repaying your direct loans?

Fast-forward to the end of your education: Now you have to think about repaying your direct loans. Again, the amount and length of your payment plan is going to depend on the type and total amount of your loans. The standard plan, though, is to pay a fixed amount each month until the loan is paid back in full. Monthly payments must be at least $50, and you have ten years to complete the repayment. Another option is the graduated plan. Graduated repayment of your loans means that your monthly payment will increase every two years. This plan is especially handy if you expect your income to grow over time. The graduated plan also allows up to ten years for repayment [source: Federal Student Aid].

If your direct loan debt totals more than $30,000, you may qualify for the extended payment plan. Under this plan you can take up to 25 years and have the option to use either fixed or graduated monthly payments. Two other payment plans, the income contingent plan and the income-based repayment plan, are (as the names suggest) dependent on your income. These plans are designed to ensure that repaying the loan will not cause undue financial strain and the monthly payment will be adjusted annually to fit your income. Determining which program you qualify for is dependent on your loan type, as well as the ratio of debt to income. The income-based plan is relatively new, and it's designed for cases of financial hardship. See this Q&A to learn more about the differences between the income contingent and income-based plans.

Consolidation is something to consider as you weigh your repayment options. If you have multiple loan payments every month, consolidating all of your federal direct loans can help you manage the debt. Consolidating is free and can decrease the total amount you pay per month, but like all extended loan agreements, you'll ultimately pay more because of the interest.

If picking a plan seems daunting, don't worry -- you aren't necessarily stuck with it. If a new payment plan is released while you're paying off your loan, or your changing financial situation makes a different plan more appropriate, the direct loan program allows you to switch without penalty.

Still have questions? Don't worry, you're not alone. See the next page for lots more information about direct loans.