From Application to Repayment: How Do Student Loans Work?

What Is a Student Loan?

A student loan is a financial aid offered to students pursuing higher education to help pay for expenses such as tuition, transport, books, and boarding.

These loans are typically provided by the federal government or private financial institutions and must be repaid over time with interest.

Student loans are debt extended to the students, which should be gradually repaid after graduation. They differ from grants or scholarships, awarded based on need or merit, and don’t require the student to repay the money.

How Do Student Loans Work?

Student loans function similarly to other types of loans but with a few unique features tailored to meet the needs of students pursuing higher education. Borrowed funds can be used the funds to pay for education. You then need to repay the loan, including all the fees accrued.To better understand how student loans work, let's explore some basic terms:

Loan Repayment: The Process of Paying Back Your Student Loan

Loan repayment is how borrowers repay the borrowed money, including the principal and the interest accrued. Repayment typically begins after a grace period, a set amount following graduation, or a reduction in enrollment status. The grace period allows students to find employment and establish their finances before beginning loan payments.

Interest Rate: The Cost of Borrowing Money.

Interest rates are based on a portion of the loan principal, independent of your loan principal. These rates can be fixed or variable, and they determine the overall cost of borrowing. Federal student loans generally offer lower interest rates compared to private loans, and the rates are often fixed, providing more predictable monthly payments.

Principal: The Original Loan Amount.

The principal is the original money you borrowed from a lender, not including interest and additional fees. When borrowers make monthly payments, a portion goes toward reducing the principal balance, while the remaining amount covers the interest accrued.

Student Loan Origination Fees: Additional Costs for Loan Processing

Origination fees are one-time charges that lenders impose for processing a new student loan. The origination fee is usually a percentage of the total loan amount and is deducted before the loan is disbursed to you. Federal student loans have origination fees, whereas private lenders may not charge them

Types of Student Loans

Federal Student Loans: Government-Backed Loans for Education

The U.S. Department of Education funds federal student loans and generally offers more flexible repayment options and lower interest rates than private loans. There are four main types of federal student loans:

Direct Subsidized Loans: Need-Based Loans for Undergraduate Students.

Direct subsidized loans are available to undergraduate students who demonstrate financial need. Whether you are financially independent and your school year is two of the most important determining factors for the loan amount allocated to you. Also, no interest accrues while you are in school or during deferrals. For direct subsidized loans, interest begins to accrue after graduation or if you drop below the half-time status.

Direct Unsubsidized Loans: Non-Need-Based Loans for Students

Direct unsubsidized loans are available to undergraduate, graduate, and professional students, regardless of financial need. For direct unsubsidized loans, interest accrues at all times, including while you are still in school and during the grace period.

Direct PLUS Loans: Credit-Based Loans for Graduate Students and Parents

These loans are available to graduate or professional students and parents of dependent undergraduate students. You will need to undergo a credit check when applying for this loan. A direct PLUS loan charges a significantly higher interest rate but offers fewer restrictions to its expenditure, which can be used to cover expenditure gaps not covered by subsidized or unsubsidized loans.

Direct Consolidation Loans: Combining Federal Loans into One Payment.

Direct consolidation loans allow borrowers to combine multiple federal student loans into a single loan with a fixed interest rate. Although this allows for the simplification of payment and the extension of the repayment period, you are also required to pay more interest over time.

Private Student Loans

Banks, credit unions, and online lenders offer private student loans as an alternative funding source. These loans differ from federal loans as they have varying interest rates and loan amounts set by the lenders.

These loans are only available to students with a credit score of 670 or higher, which can be difficult for undergraduates with limited credit history. As a result, co-signers are often required for eligibility.

In addition, please note that private loans often lack the protections offered in federal loans, such as loan forgiveness, deferment options, and income-driven repayment plans.

As a result, students should explore federal loan options before turning to private loans.

How Does Student Loan Interest Work?

Understanding the Cost of Borrowing for Education

Student loan interest is the cost borrowers pay lenders for borrowing money to finance their education. As the borrower, you are responsible for paying any interest accrued as determined by your interest rate, which is calculated as a percentage of the principal amount. How much interest you should pay is determined by the interest rate.

Interest Capitalization: Adding Unpaid Interest to the Principal Balance.

For some loans, such as unsubsidized loans, interest accrues while the borrower is still in school. If interest accrues for too long without payment, it may capitalize. This means it is added to the principal, increasing the amount owed.

Federal Student Loan Interest Rates:

Federal loan interest rates are set by Congress, varying based on the year the loan was first disbursed, and are fixed during the loan’s lifetime. For loans disbursed between July 1, 2022, and July 1, 2023, the rates are as follows:

Direct Subsidized and Unsubsidized Loans for undergraduates: 4.99%.

Direct Unsubsidized Loans for graduate and professional students: 6.54%.

Direct PLUS Loans: 7.54%.

Private Student Loan Interest Rates:

The interest rates of private loans are either fixed or variable, as different lenders have their standards.

The interest rates for private student loans are variable throughout the loan’s lifetime, ranging between 1% to 15%, and depend on the borrower’s credit score. As of Feb. 27, 2023, the 5-year variable rate for private student loans is 9.24%, while the 10-year fixed rate is 7.94%.

How to Estimate Your Loan Costs？

Way 1 Use a Loan Calculator.

You can use a loan calculator, like the one available on MU30, to estimate the interest that will accrue on a given loan.

Way 2 Divide the Loan’s Interest Rate by 365.25

To calculate the daily interest rate on your student loan, divide the interest rate by 365, which is the number of days in a year, including Leap Year.

For instance, if your interest rate is 4%, your daily interest would be 0.04 ÷ 365 = 0.0001095, the interest rate factor or daily rate on your loan.

To calculate the daily interest amount, multiply your current loan balance by the daily interest rate. For instance, if your current loan balance is $10,000, your daily interest amount would be 0.0001095 × 10000 = $1.10.

To calculate your monthly interest amount, multiply the daily interest amount by the number of days in the month’s billing cycle. For instance, if the number of days is 31, the monthly interest amount would be 1.10 × 31 = $34.10.

You can also calculate the monthly interest amount simply by following this formula:

The outstanding principal balance (unpaid loan amount) x the days since your last payment x the interest rate factor = interest amount.

Remember that the formula provided above is a simplified version of the actual calculation. Depending on the loan terms and repayment plan, the calculation may vary.

How Much Can You Borrow Through Student Loans?

For federal loans, your college will determine the amount you can borrow, subject to certain limits:

Undergraduate Federal Direct Stafford Loans.

Dependent undergraduate students can borrow $5,500 for first-year undergraduates, $6,500 for second-year undergraduates, and $7,500 for third-year undergraduates, with an aggregate limit of $31,000.

Independent students can borrow $9,500 for first-year undergraduates, $10,500 for second-year undergraduates, and $12,500 for third-year undergraduates, with an aggregate limit of $57,500. The aggregate limit for graduate or professional students is $138,500.

Graduate Federal Direct Stafford Loans.

Graduate and professional students: up to $20,500 annually, with aggregate limits of $138,500.

Medical school students: up to $40,500 per year.

Federal Direct PLUS loans.

Federal Direct PLUS loans are subject to aggregate loan limits, meaning there's a cap on the total amount you can have in outstanding loans. The maximum a student can borrow under a Direct PLUS loan is the cost of attendance without additional financial aid. However, a Direct PLUS loan has no fixed annual or aggregate loan limits.

Private Loans.

The amount you can borrow from private lenders varies based on the lenders and typically doesn’t exceed the total cost of your college tuition minus other financial aid. Your credit score, existing debt, prospects of your field of study, and the co-signers financial strength are some of the factors that private lenders consider in the matter.

The Amount You Should Borrow.

When considering student loans, borrowing only what you need to cover educational expenses is essential. Taking on excessive debt can lead to financial strain and difficulty repaying loans after graduation.Before deciding on the loan amount, you should consider scholarships and grants, the potential return on investment, and the employment rate of your field of study.

What Can Student Loans Be Used For?

Student loans can be used to cover various education-related expenses, including:

• Tuition and fees.
• Room and board (on-campus or off-campus housing).
• Books, supplies, and equipment.
• Transportation costs related to attending school.
• Childcare expenses for student-parents.
• Miscellaneous personal expenses associated with attending school.

It's important to note that student loans should be used responsibly and only for necessary educational expenses to avoid taking on unnecessary debt.

How to Apply for Student Loans?

To apply for student loans, follow these steps:

1. Complete the Free Application for Federal Student Aid (FAFSA).

To be considered for federal student loans, students must complete the FAFSA, which is used to determine their eligibility for financial aid. The FAFSA is available online at fafsa.gov. You'll need to input personal details for the student and yourself, such as names, Social Security numbers, and birthdates. Additionally, you'll provide demographic and financial data before signing and submitting the application.

2. Review Your Financial Aid Offer.

After submitting the FAFSA, you will receive a financial aid offer from the schools you've been accepted to. This offer will outline the available grants, scholarships, work-study opportunities, and loans. Review the offer carefully to understand the types and amounts of loans you're eligible for.

3. Confirming Your Loan Choices.

If you decide to accept federal student loans, you must get the loan offer through your school's financial aid office. Follow their instructions to complete the steps to secure your loans.

4. Apply for Private Student Loans (if needed).

Consider private student loans only if federal loans and other readily available financial aid options don’t cover all your educational expenses. Research and compare lenders to find your situation's best loan terms and interest rates. Remember that private loans often require a credit check and may have less flexible repayment options than federal loans.

How Much Do Student Loans Cost?

Federal Student Loan

Although Congress sets federal student loan interests, the rates vary depending on the type of loan. The interest rates for the 2022-2023 academic year are as follows:

• For undergraduates: 4.99% for direct subsidized and unsubsidized loans
• For graduate and professional students: 6.54% for direct unsubsidized loans
• For graduate or professional students and parents of dependent students: 7.54% for direct PLUS loans

Student Loan Repayment Options

Federal Student Loan Repayment:

Federal student loans offer borrower-friendly terms, including a six-month grace period after graduation before repayments begin. The standard repayment plan assumes a 10-year repayment period. However, alternative repayment plans, or income-driven repayment (IDR) plans, are also available. IDR plans to adjust your monthly payment based on your discretionary income. There are four IDR plans:

1. Income-Based Repayment Plans (IBR):

Monthly payments are 10% to 15% of your discretionary income, which is your income after taxes and essential expenses. Balance forgiveness after 20 or 25 years is also offered depending on the year the loan was borrowed. Borrowers who took out loans after July 1, 2014, qualify for more favorable terms (10% of income and forgiveness after 20 years).

Loan forgiveness: 20 or 25 years, depending on when you first borrowed.

2. Income-Contingent Repayment Plans (ICR):

Monthly payments are 20% of the amount you would pay under a 12-year fixed payment plan.

Loan forgiveness: after 25 years, depending on when you first borrowed.

3. Income-Sensitive Repayment Plan

Monthly payments are based on the annual income for up to 10 years.

4. Pay As You Earn (PAYE).

Monthly payments don’t exceed 10% of the discretionary income or the standard repayment plan. Loan forgiveness is granted after 20 years.

Loan forgiveness: after 20 years, depending on when you first borrowed.

5. Revised Pay As You Earn (REPAYE)

Monthly payments are equal to 10% of the discretionary income, but there are no guarantees on the lower payments as compared to those offered under the standard repayment plan.

Loan forgiveness: after 20 or 25 years, depending on when you first borrowed.

Repaying Private Loans.

Private student loans are less flexible than federal loans, with repayment terms of 5 to 20 years, varying interest rates, and varying grace periods based on the lenders. The relief period for most private student loans is 12 to 24 months, and interest accrues during school and deferment.

However, various private student loan lenders offer the following plans to accommodate student financial situations:

Starting Repayment While in School:

Some lenders allow students to make payments while still in school, although the terms may differ depending on the lender. Some lenders will enable you to cover only the interest or make smaller payments, while others may require you to make total payments even while at school.

Postponing Payments Until Graduation:

Some private lenders allow you to delay your payments until after graduation and even provide a grace period of about six or more months, which can ease the pressure as you look for a job.

Adaptable Deferment Options:

Some private lenders offer greater flexibility with their terms. For instance, they temporarily allow borrowers to halt or miss a payment during financially challenging periods. You may also refinance a higher variable interest rate, enabling borrowers to secure more advantageous terms while facing financial challenges.

What to Do if You Can’t Afford Your Monthly Payment?

Understanding these alternatives can help ease financial stress and ensure the successful repayment of your loans.

Considering Refinancing Student Loans:

Refinancing is an excellent option for some borrowers, as it can accelerate loan repayment. Refinancing is not the best option for everyone. You should consider the following conditions before deciding on it:

• Refinancing should be free of charge.
• Choose a fixed interest rate to prevent unexpected rate increases.
• Opt for a shorter loan repayment term to speed up the process.
• Secure a lower interest rate to minimize the overall cost.

Refinancing may only be the ideal strategy if these conditions are met.

Contact your loan servicer:

If you cannot make monthly payments, contact your loan servicer to discuss deferment or forbearance options for temporarily pausing payments. You should also consider loan forgiveness an option, especially if you’ve borrowed a federal student loan.

Deferment:

Deferment allows the suspension of the loan for up to 3 years when federal student loans do not accumulate any interest. Therefore, it is often the better financial choice for subsidized federal loans. Eligibility for deferment is based on unemployment or significant financial hardship, such as homelessness, military deployment, or major medical treatments.

Forbearance:

Forbearance may be an option if you don't qualify for deferment. It allows loan payments to be paused or reduced for up to 12 months.

Interest accrues during the forbearance period, unlike the case with deferment. Therefore, you should consider an income-based repayment because it offers a better option than deferment and forbearance, allowing you to make payments without additional interest.

Student Loan Forgiveness:

The Public Service Loan Forgiveness (PSLF) program allows the forgiveness of the remaining debt to students working in public service careers after making 120 consecutive, on-time payments. PSLF applies only to federal student loans, and refinancing with a private lender makes you ineligible for forgiveness.

Default:

Default occurs when a borrower misses nine months' student loan payments. This severely impacts credit scores and can result in wage garnishment.

To avoid defaulting on your loan, try to make on-time payments, and where that’s inapplicable, apply for a loan restructuring plan from your student loan service. You could also consider options such as income-based and income-contingent repayment in times of financial crisis. If offered a payment break, keep in mind that the interest still accrues during that period, which increases the overall amount.

FAQs

What Happens to Student Loan Debt When You Pass Away?

Federal student loans are forgiven if the primary borrower passes away. Parent PLUS loans are also forgiven if either the parent borrower or the student dies.

For private student loans, the outcome depends on the lender's policies, which can vary. Ensure you check with the lender on their loan forgiveness policies before you borrow the loan.

How Long Does It Take To Pay off Student Loans on Average?

The repayment duration for student loans depends on the loan type and chosen repayment plan. The standard repayment period for federal student loans is ten years, while the repayment period for private student loans is between 20 to 30 years, based on the lender. Generally, shorter repayment terms come with lower interest rates and faster repayment results in lower overall costs.

Can I Get a Student Loan Without My Parents’ Assistance?

Yes, you can obtain student loans without your parents' involvement. While some borrowing options may be more limited, federal student loans do not require a parent borrower or cosigner. Additional options include tuition installment plans, having an adult other than your parent act as a cosigner, and qualifying as an independent student to get a higher federal loan limit.

Do Student Loans Damage Credit?

Student loans do not inherently damage credit.Timely payments can improve your credit score, while late payments and defaulting can damage it. Maintaining consistent and timely payments is crucial for maintaining a healthy credit score.