How Student Loans Work

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

There are three types of student loans a person can get from the U.S. government: Direct subsidized, direct unsubsidized and direct PLUS.

The process of obtaining one of these three federal student loans starts with filling out the Free Application for Federal Student Aid (FAFSA). If you are considered a dependent by the department of education, you will need to include your parents' financial information. Tip: Even if you aren't sure that you want to take out loans, the FAFSA can be your gateway to other types of aid like the Pell Grant. The FAFSA is relatively easy and can pull your financial information directly from the IRS.

While federal student loans are some of the best available, there are some downsides.

For instance, there are also usually limits to the amount you can borrow from the U.S. government. In 2020, the limits for the direct subsidized and unsubsidized loans for undergraduate students range from $5,500 to $12,500 per year as determined by the student's dependency status, according to Federal Student Aid, an office of the department of education. The total aggregate borrowing limit for a dependent undergrad is $31,000 or for an independent undergrad is $57,500.

Setting borrowing limits might be helpful in keeping young students from incurring too much debt while in school, but with the average private school tuition ringing in at $36,801 per year in 2019-2020, many parents have to take out extra loans to cover costs.

Keep in mind that in addition to tuition, families are responsible for room and board, activity fees, technology fees, transportation, books and supplies and other costs. For some people, federal student loans won't cover all of college, and so financial aid advisers tend to suggest using federal loans as ways to close the gap between tuition and fees and scholarship and grant money.

"The best guideline is to tell students that they should borrow only as a last resort and, if they must, to borrow as little as possible," says Andrew Pentis, personal finance expert and certified student loan counselor with Student Loan Hero. "From that point, they can work out the math to see if they can actually afford what they're planning to borrow. They can do this by estimating their monthly payments down the road and projecting their future post-tax salary. They can even create a mock postgraduate budget to ensure the monthly payment is a feasible amount." A variety of calculation tools are available on the Student Loan Hero website.

In 1998-1999, 60 percent of direct loans were subsidized, but by 2018-2019, only 29 percent were, according to CollegeBoard's "Trends in Student Aid 2019" report.

Whichever type of loans you are awarded, and it will likely be a combination of the subsidized and unsubsidized, disbursement of the funds will 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, and then subtract any scholarship, grant money or any other financial assistance you may have. Any remaining balance will be deducted from your student loan, and if there is money left over, you can opt to receive it in the form of cash, a check or a direct deposit into your bank account. Know that you will also have to pay loan fees, which will also be deducted before you receive any surplus.

You can also have the school hold the surplus from your student loans for the next academic year, which is the wise choice. 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.

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.

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. Because it saves them money, private lenders may offer a quarter percentage point off the interest rates they charge when you sign up for automatic payments. (Note that federal student loan servicers may do this too.)

Banks also offer other perks. You might get a rate discount for submitting payments on time, can receive a kickback for referrals or even benefit from loyalty yourself, according to Student Loan Hero. When you refinance student loans with a private lender, you could also benefit from a cashback bonus in addition to a lower interest rate, according to Student Loan Planner. Although they are not required to do so, some lenders offer deferments, usually around six months following graduation (more on that on the next page).

But student loans from private banks also have their disadvantages. For starters, you may not be eligible for one. Like traditional loans from commercial banks, eligibility for private student loans, sometimes 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 co-sign on the loan. Cosigning is 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 co-signer's credit is just as on the hook as yours when repayment comes due.

With private student loans, lenders today usually offer both fixed and variable interest rates. Variable rates are 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 your loan payments if you choose a variable rate.

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 may act blindly to any scholarship or grant money you have 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 often the most expensive of their kind. Be wise with how much money you borrow.

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

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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.

With private loans, you'll have three options for repayment: full deferral, immediate repayment or interest payments.

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. Remember, unsubsidized federal loans will accrue interest while you are in school and during your grace period. The government offers a variety of terms for repayment of your student loans. 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. These can go up to 30 years when a loan consolidation has been performed. Graduated repayment is a 10-year method (or up to 30 when there has been a loan consolidation) where repayment begins with low monthly installments and gradually increases over time. This is meant to reflect the increase in salary professionals usually experience during their careers.

As of 2020, the department of education offers four types of repayment methods based on the income levels of the borrower. Income-driven repayment options include:

Each has a payment amount based on the borrower's "discretionary income," generally 10 to 20 percent of it.

With the four existing income-driven repayment plans, borrowers pay for 20 to 25 years and must update income information each year, which means payments fluctuate. During repayment, interest continues to accrue, which means your balance at year 25 could be greater than your balance at year one if your payments have been too low to even cover your interest.

All direct loans and direct PLUS loans made to graduate or professional students are eligible for the income-driven repayment plans. Direct PLUS loans made to parents are only eligible for the ICR and only if the loans have been consolidated. Older loans are generally eligible if they have been consolidated, but PLUS loans to parents might again cause an issue.

So what happens if you still have a balance after paying for 20 or 25 years? We'll talk about student loan forgiveness next.

You may be wondering what happens to the remaining balance at the end of your 20- or 25-year payment term. Does income-driven student loan repayment work like a balloon mortgage, requiring that the balance be paid in full at the end of the loan term? Thankfully not. According to Federal Student Aid, "Under all four plans, any remaining loan balance is forgiven if your federal student loans aren't fully repaid at the end of the repayment period."

Another program might help you reach the loan forgiveness grail even faster. The Public Service Loan Forgiveness (PSLF) plan forgives the remaining balance on direct loans after just 120 qualifying monthly payments (or 10 years) that you made under a qualifying repayment plan if you're working full time for a qualifying employer. To be eligible, you need to work for a government or nonprofit organization. AmeriCorps and Peace Corps count here too, but labor unions, partisan political organizations and for-profit organizations do not, even if they have government contracts.

But PSLF has been getting some bad press since the first wave of possible loan forgiveness borrowers have reached their 10-year term. Forbes contributor Preston Cooper reported that 99 percent of loan-relief applications were rejected. However, the majority of them had not made the required 120 minimum payments, while others were missing information from their application, did not have eligible loans or did not work for a qualifying employer. Be sure to check the requirements carefully if you are seeking this type of loan forgiveness.

Whether taking 10, 20 or 25 years, income-driven repayment ending in student loan forgiveness sounds pretty amazing for the borrower, especially one with a significant amount of student loan debt who had been thinking the loans would surely die with them.

However, borrowers should be aware that student loan forgiveness may have an unwelcome effect on their tax return. Referred to as a "tax bomb," it comes from the requirement that the forgiven amount is supposed to be reported on your tax return as income, although there may be exceptions. In an article for Student Loan Planner, Stephen Mercer explained that the hit could be as much as 37 percent of the amount forgiven depending on your taxable income. The tax bomb applies only to the 20- to 25-year income-driven repayment plans. With PSLF forgiveness, your balance is not considered taxable income.

Travis Hornsby, founder of Student Loan Planner, told us he isn't so sure the tax bomb will become reality, questioning whether the government will really try to collect on someone who paid on-time student loan payments for up to 25 years. Of course, it's too soon to tell, and there is no guarantee. "It's 'reading the tea leaves'," he says. In anticipation of the possibility, he suggests putting some money in an investment account just in case you need it down the road for the tax hit.

But even with all of these repayment options, some borrowers simply find that they don't have the cash they thought they would after graduation. Read about what it means to default on student loans on the next page.

The Department of Education defines student loan default in different ways depending on the type of loan. Once a loan payment is a day late, the loan is considered delinquent. After 90 days, your delinquency will be reported to the three credit bureaus. With direct loans and those made under the FFEL program, a borrower who does not make a scheduled payment for at least 270 days will be considered in default. Borrowers in default 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 or by email. Lenders and servicers 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 sending in those monthly payments, look into ways your lender may allow you to change the terms of your loan repayment.

Some 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 of 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 federal loans to be consolidated, or you can refinance private loans with a commercial lender. You can also combine private and federal loans into a private-lender refinance. There are pros and cons to each of the scenarios, so make sure you understand what you are gaining and losing. It may help to seek advice from an outside source like the nonprofit National Foundation for Credit Counseling (NFCC) or a financial planner.

If you've defaulted on your federal student loans, you can also opt to rehabilitate your accounts. This is simply making payments again. Don't worry that the payments will be the same ones that you could not afford in the first place. During rehabilitation, your loan holder will determine a new payment for you based on your discretionary income. 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. Note that federal student loan rehabilitation is a one-time opportunity.

Understanding student loans, repayment, defaulting, consolidation, refinancing and forgiveness takes effort, but it's necessary if you are considering borrowing or have already done so.

"The student loan landscape can be very confusing," says Coleman from NFCC. Considering the sweeping changes in federal student loans during the past decade and the contested nature of the topic today, it's not going to get any easier. When it comes to student loans, each borrower must look out for themselves.

How did we get here? In just 10 years, the federal student loan debt grew from a mild $750 billion to the current figure. The number of borrowers expanded too, but not in the manner of the debt. In 2010, the federal government started lending directly to borrowers rather than having banks lend money that the government guaranteed. Under the "direct loan" program, all federal student loans now come through the Department of Education, which accounts for much of the drastic jump in debt, according to Student Loan Hero.