How Student Loans Work


You've got a bright future ahead of you. You just have to figure out how to finance it. See more college pictures.
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So you got accepted to college. Congratulations! Now that you've run around the house and e-mailed everyone you can think of to tell the good news, it may be time to think about how you'll pay for your higher education.

Financial aid experts recommend that you spend a lot of time cobbling together as many grants and scholarships as possible to pay for school. It's a rare student who gets a free college education, however. When you've exhausted every avenue toward free money, it's time to look at student loans.

Student loans come in a variety of types. Some are based on financial need, while others are much like any other loan and are based on your credit score. They all have one thing in common, though: They must be repaid eventually and normally reach into the tens of thousands of dollars. Knowing what student loans fits your situation best and just how much you'll need, can help save you money in the long run, both in interest and principal.

In this article, we'll look at student loans and what makes them different. Up first are federal student loans.

Federal Student Loans

With student loans, the money goes to your college, not you. Any remaining balance will be given to you by the school or you can tell them to keep it until next year.
With student loans, the money goes to your college, not you. Any remaining balance will be given to you by the school or you can tell them to keep it until next year.
©iStockphoto/sshepard

As student loans go in the United States, those issued by the federal government are about as good as they come. There's a good reason for that: Federal student loans offer low, fixed interest rates. This makes them much more attractive than private loans from commercial lenders.

That said, there are some downsides to federal student loans. The availability of some loans, like the Perkins loan, is based on need. Even if you could really use the loan, the federal government may deny your application based on the adjusted gross income of your household. There are also usually limits to the amount that can be borrowed from the U.S. government. In 2009, the limits for the Stafford loan began with $5,500 for a student's freshman year and ending with $7,500 for senior year, with a total limit of $31,000 [source: Kantrowitz]. That same year, the estimated average cost for an in-state student at a public school came to just over $28,000 [source: Lewin]. For some people, federal student loans won't cover all of college, and so financial aid advisors tend to suggest using federal loans as a way to close the gap between tuition and fees and scholarship and grant money.

There are two different ways you can get student loans from the federal government: directly from the Department of Education (Direct Loan) or through a private lender that's a member of the government's Federal Family Education Loan (FFEL) program. Both of these loans have the same interest rates; criteria for eligibility and maximum amounts one can borrow are also the same. The difference lies in repayment of the loan -- more on that later.

Both of these methods of disbursement will actually go to your school, not to you. The school will tally the total amount of your tuition, fees and any other charges the school levies, subtract any scholarship, grant money or any other financial assistance you may have. Any remaining difference will be deducted from your student loan and whatever is left over will be given to you in the form of cash, a check or a direct deposit into your bank account.

You'll also be given the option to allow the school to hold the surplus money from your student loans for the next year. This may be a wise idea. After a year in school, you will have a better idea of the amount you'll need to borrow for your second year. You may need to borrow less than you think.

Read the next page to learn about the different kinds of student loans.

Types of Federal Student Loans

Some types of teaching positions can get your student loans forgiven, if you qualify. Not a bad deal.
Some types of teaching positions can get your student loans forgiven, if you qualify. Not a bad deal.
©iStockphoto/RonTech2000

There are three broad types of student loans a person can get from the U.S. government: Perkins, Stafford and PLUS.

The Perkins loan is a federal loan where the college the student is attending is the lender. The college gets the money for the loan from a pool established and funded by the U.S. government. Because of the size of the pool, competition for Perkins loans is intense, and qualifications are based on need. Students with the greatest financial need are the likeliest to receive a Perkins loan.

Perkins loans are unique in that they have more favorable terms for the borrower, like a nine month (as opposed to six) deferment period for repayment. What's more, Perkins loan recipients can also have their loan entirely cancelled in exchange for entering the public service sector, like the military, civil service or some teaching jobs for a set amount of time following college.

Stafford loans are the most commonly-issued type of federal student loan. These loans are so common, in fact, they're the ones that the widely published borrowing limits are centered around. How much to allow a student to borrow for a Perkins loan, for example, is largely left up to the university's financial aid office. Stafford loans, on the other hand, are strictly regulated by federal rules. Rather than being based on financial need or credit score, these loans are generally available to any student. These loans have low interest rates; the rate on a typical new Stafford loan is fixed at 6.8 percent [source: Department of Education]. Depending on which program your school takes part, Stafford loans will either be disbursed directly or under the FFEL program.

Parent PLUS loans are federal student loans borrowed by a student's parents. Out of all the types of federal loans, these most resemble a traditional commercial loan. Whether parents are eligible for a PLUS loan is based on their credit score, and interest rates are higher than Stafford or Perkins loans, fixed between 7.9 and 8.5 percent [source: Department of Education]. The cost of attendance at the university the student will be enrolled sets the limit for what a parent can borrow. There is also a PLUS loan program for graduate students as well.

If you've exhausted your limit for federal student loans and still find yourself short on money for tuition, it's time to look to the private sector for help. Read the next page for information on private student loans.

Private or Alternative Loans

Parents often make excellent cosigners on student loans. It can't hurt to ask.
Parents often make excellent cosigners on student loans. It can't hurt to ask.
©iStockphoto/sjlocke

Banks have been in the commercial lending business a lot longer than the U.S. government. This is both good and bad for you, the borrower. Having lent money longer, banks offer more advanced features for your loan, like automatic debit from your account. Many private lenders offer a quarter percentage point off the interest rates they charge, because it saves them money. They also offer deferments, usually around six months following graduation (more on that on the next page).

But student loans from private banks also have their downsides. For starters, you may not be eligible for one. Like traditional loans from commercial banks, eligibility for private student loans, also called alternative student loans, is based on your creditworthiness. If you have bad credit, you may not get a bank to lend to you. If this is the case, you may still be able to get a loan if you can come up with a friend or relative who's willing to cosign on the loan. Cosigning is very common for private student loans since most teenagers don't have the credit history to get a loan of such size. Be aware, however, that the cosigner's credit is just as on the hook as yours when repayment comes due.

With private student loans, interest rates are variable. They're based on one of two indices, the LIBOR (the London Interbank Offered Rate, or the rate banks charge one another for loans) or the prime rate (the rate at which the most creditworthy people can borrow money). This rate will be added to an additional percentage margin, based on your creditworthiness. Since the LIBOR and the prime rates fluctuate, so too will the interest rates on you loan payments.

Like federal student loans, the bank will disburse funds to your school. You can usually borrow up to the full cost of tuition and fees. Unlike some federal loans, banks act blindly to any scholarship or grant money you have coming your way to pay for tuition. So you can borrow all of the money you need to attend, even if you don't require that much. Any amount left over will be disbursed to you by your school. Again, remember that borrowing money is the most expensive way to pay for an education, and private student loans are the most expensive of their kind. Be wise with how much money you borrow. A good rule of thumb is to borrow no more than the average annual salary of the job you're planning on pursuing after graduation [source: Kantrowitz].

On the next page, we'll look at how interest may or may not accrue, depending on whether your loan is subsidized.

Subsidized Versus Unsubsidized Loans

People do hold down real jobs to put themselves through school. Hats off. If you're qualified for a subsidized loan, you may not have to.
People do hold down real jobs to put themselves through school. Hats off. If you're qualified for a subsidized loan, you may not have to.
©iStockphoto/thelinke

Depending on the type of loan you get, you may be able to stave off the accrual of interest during certain periods. Loans that are subsidized don't accrue interest during certain periods; unsubsidized loans don't include this attractive feature. In the U.S., the federal government pays the interest that builds up on loans it subsidizes while the student is in school. When you emerge a graduate, you will begin your repayment without an additional hefty four or five years of interest attached.

Loans that may be subsidized are federal in nature. The U.S. Department of Education makes interest payment on its subsidized Stafford loan and on Perkins loans. Not every federal student loan is subsidized, however. Stafford loans may be issued with unsubsidized terms and federal PLUS loans are always unsubsidized.

The decision over government subsidization of a loan is based on financial need. The lower the household income, the likelier the student will qualify for a subsidized loan. Around two-thirds of subsidized Stafford loans go to families with adjusted gross incomes for the household of $50,000 or less [source: FinAid].

If you don't qualify for subsidization, don't worry about having to get a nine-to-five job while you're in school, just to make the payments on your student loans. Unsubsidized loans, as well as most student loans from private lenders like banks, include a deferment period from the beginning of enrollment, throughout school and to three or more months following graduation. The interest will accrue during this time, but you won't have to pick up payments until you've had a couple months to get on your feet after you graduate.

As we've seen, the government sets annual limits based on college year for the amount that can be borrowed. For unsubsidized loans, the numbers are smaller. For example, freshman could borrow $5,500 in 2009 for an unsubsidized loan, while the limit was $3,500 for a subsidized loan [source: Department of Education]. Students who receive subsidized loans can still borrow up to the unsubsidized limit from the government, but the difference will be unsubsidized.

Now that you've got your mortarboard, a job and a new life, it's time to begin the long, long journey of repaying your student loans. Read about what you can expect on the next page.

Repaying a Student Loan

Now that you're out in the real world it's time to repay those student loans. How long you have to do so depends on the repayment method you choose.
Now that you're out in the real world it's time to repay those student loans. How long you have to do so depends on the repayment method you choose.
©iStockphoto/shironosov

One of the decisions you'll have to make when you take out your student loan, whether it's federal or private, is how your repayment will be structured. You'll have several choices presented to you.

With private loans, you'll have three options for repayment: full deferral, immediate repayment or interest only. Full deferral allows you to put off making any payment on your loan until six months after you've graduated. Remember that interest will accrue throughout the time you're enrolled in classes, since private loans aren't subsidized in any way. The accrued interest will be added to the balance that you will begin to repay after you graduate. The good news is, depending on your income level, you can deduct up to $2,500 of that interest on your taxes each year.

Immediate repayment is pretty much what it sounds like; 45 days after enrolling, you will begin repaying your student loans. This method prevents an accrual of interest building up. Last is the interest only payment, where you make payments while enrolled in school, but on only on the interest. This usually means lower monthly payments and prevents interest from accruing.

Federal loans have a slightly different repayment structure. Like private loans, you will have the option of full deferral, throughout the time you're enrolled above half-time and usually for a full six months after you graduate. But the government offers much more attractive terms for repayment. Lengths of time given to repay run from 10 to 30 years.

Standard and extended repayment plans are similar, but cover a period of 10 and 25 years, respectively. Graduated repayment is a 10-year method where repayment begins with low monthly installments and gradually increases over time. This is meant to reflect the increase in salary professionals usually experience over their careers.

Three types of repayment methods are based on the income levels of the borrower. Income based repayment is a capped amount repayment schedule, and extends past 25 years. It's a new plan and after 25 years of repayment, the remaining balance may be forgiven in some cases. Income contingent plans are calculated each year based on the adjusted gross income of your household and doesn't exceed 20 percent of your monthly income. Income-sensitive plans span 10 years and are based on your annual income. They're calculated each year and increase in step with your yearly salary.

But what exactly happens if you simply find that you don't have the cash you thought you would after graduation? Read about defaulting on student loans on the next page.

Defaulting on a Student Loan

It may be tempting to stop repaying your student loans, but there are alternatives to defaulting.
It may be tempting to stop repaying your student loans, but there are alternatives to defaulting.
©iStockphoto/killerb10

Before the U.S. government revised the laws regarding bankruptcy in 1992, it was reasonably easy for a person to default on a student loan. A borrower could simply stop paying and there wasn't much that lenders -- including federal lenders -- could do about it. Because of this, default rates hit their highest point in history, an amazing 22.4 percent (these days the average usually hovers around 6 percent) [source: Kumar]. After 1992, however, it became much more difficult to default. To discharge -- essentially make a loan simply go away -- a student loan, a person had to file bankruptcy. After 2005, when further revisions were made, it became virtually impossible to discharge a student loan. Debtors could look forward to harassing phone calls, years of low credit scores and even garnished wages.

This is why it's never a good idea to default on your student loans. Once you've chosen a repayment type, it's easy to repay a student loan. Each month following the three- or six-month grace period after graduation, you'll receive a bill in the mail. You write a check and mail it off. Even easier, many lenders offer direct withdrawal from your bank account; no check or stamp necessary.

It's simple enough, yet sometimes it's not quite as easy as that. Jobs fall through, layoffs happen, economies tank and bills pile up. While it can be tempting to simply stop mailing in those monthly payments, look into ways your lender may allow you to change the terms of your loan repayment.

Most private lenders and the federal government offer forbearances, periods where repayment of your loan may be suspended without penalty. The interest will continue to accrue, but you may be eligible to get a few months up to a couple years off while you get your finances in order.

If you're swimming in student loans from several sources, you can consolidate them into one monthly payment. The federal government allows loans to be consolidated, but through another, single loan from a commercial lender. The good news is that the loans that you fell behind on and lowered your credit score will be wiped clean. This means your credit should increase favorably with reporting agencies. The bad news is that your new consolidation loan is a private one, meaning you won't have the attractive terms of a federal loan (or loans) any longer.

If you've defaulted on your federal student loans, you can also opt to rehabilitate your accounts. This is simply making payments again. After nine payments made on time over 10 months, you will be considered current once more and the default status will be removed from reports to credit bureaus.

For even more information on student loans and financial aid, visit the next page.

Related HowStuffWorks Articles

Sources

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