How Do Student Loans Work?

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For more than 40 million Americans, student loans are the key to higher education. The average cost of tuition has more than doubled in the last 30 years, and few students can afford to pay $20,000 or $30,000 a year for college. But it’s important to understand how student loans work before committing to their terms.

What Are Student Loans?

A student loan is money borrowed from the government or a private lender to cover the costs of college. The loan collects interest and must be paid back later, usually after graduation.

You can apply for student loans by filling out the Free Application for Federal Student Aid (FAFSA).

Gather federal tax information, bank statements, pay stubs, and other important financial information to complete the FAFSA form. If you’re a dependent, use your parents’ information. If you’re an independent student, use your own.

FAFSA sends your application to your schools of choice, which determines how much aid you qualify to receive. You’ll receive an “award letter” with all of the details. Aid is available through FAFSA in the form of student loans, scholarships, and grants.

You can also apply for private student loans through a bank. However, private loans tend to be more expensive and assign higher interest rates than federal loans. Private loans also lack the flexibility of federal loans; you must make monthly payments while you’re still enrolled in school.

The COVID Update

In March 2020, most student loan payments were paused without you having to do anything. Originally meant for 6 months, it has now paused to January of 2022.

Recently, President Biden canceled $5.8 billion of student loan debt for disabled borrowers, which accounts for more than 323,000 people. It is unknown at this point if there will be broader loan forgiveness.

Types of Federal Student Loans

The majority of college students choose federal loans because they offer certain perks not available from private loans. There are two main types of federal loans to understand: direct subsidized loans and unsubsidized loans. They are sometimes referred to as Stafford Loans.

With a direct subsidized loan, the government covers the interest payments on your loan while you’re still enrolled in school. This type of loan is only available to undergraduate students with proven financial needs. FAFSA determines the amount of your financial need and approves a direct subsidized loan up to that amount.

With an unsubsidized loan, on the other hand, you must pay all interest that accrues while you’re in school and after graduation. Undergraduate and graduate students can qualify for unsubsidized federal student loans. The amount is determined by the cost of tuition at your school, plus other aid you’re receiving.

Most undergraduates can borrow between $5,500 and $12,500 per year through Stafford Loans, while graduate students are eligible for unsubsidized loans up to $20,500.

Interest Rates and Repayment on Student Loans

Federal loans and private loans structure interest rates and repayment plans in very different ways.

Federal loans assigned fixed interest rates that never change over the life of the loan. The rates are determined by Congress. The 2020-2021 federal student loan interest rates, for example, were are 2.75% for undergraduate loans and 4.30% for unsubsidized graduate loans. (Both rates were adjusted to be lower due to COVID). In private student loans, lenders determine interest rates based on creditworthiness and other factors.

Federal student loans also offer better choices for repayment. Here are the most common repayment options for student loan holders:

  • Standard repayment plan: Pay a set monthly amount for 10 years, starting after graduation.
  • Graduated repayment plans: Monthly payments start small and gradually increase every few years, for 10 years.
  • Income-based repayment plans: The federal government allows qualified borrowers to pay a total of 10-15% of annual net income, split over monthly payments. Payments are recalculated each year to consider income and family size.

If you find yourself struggling to pay your student loans each month, the federal government also offers temporary relief in these forms:

  • Forbearance: Put your payment on hold for a set period of time. Your account remains current. However, your total loan amount continues to accumulate interest during this time.
  • Deferment: If you qualify, you can defer or “skip” a few payments and possibly have the interest covered.

Though the details of each type of student loan are varied, one factor remains the same: student loans are complicated, so do your research before agreeing to borrow such a large sum of money or double-check with your student loan servicer to double-check how much, and who you owe. Plus, make sure you have your most updated contact information on file as you may have moved around during the pandemic!

Read More: What Debts Should You Pay Off First?