Student loans are complicated. In fact, I would hazard to say that they are more difficult to understand than the series finale of Lost (if you've seen it).
This is an in-depth guide to all things student loans. Once you’re done reading this guide, you should be able to apply for, choose, receive, and pay back a student loan in your sleep. Or almost at least. Maybe? Hopefully?
My knowledge of student loans, to my own despise, stems from the massive amount of debt I had to take on to fund my education. My parents immigrated to the United States without much to their name. Because of this, I had to pay for college mostly on my own - which included using, mostly, student loans.
One thing to know before you borrow money is that no matter what type of student loan you choose, they all have a few things in common. One of those things is that your student loan is not dischargeable in bankruptcy. That means that if you owe tens of thousands of dollars in student loan debt there are very few ways to get out of that obligation.
What’s more, if you ever default on a student loan they can garnish your wages and your tax returns. There’s no escaping! For that reason, you need to be careful about how much you borrow and not see student loans as a way to subsidize a fun college lifestyle. The cool sneakers you buy with your student loan money will end up costing you a whole lot more once you pay interest on them. It’s far better to graduate debt free if possible, and it’s important from a financial standpoint to graduate with only as much debt as you need, if you cannot avoid borrowing completely.
From here on in we’ll take a look at what types of student loans there are, where they come from, how interest on them works, and the basics you need to know to borrow and repay them. Let’s get started!
Types of Student Loans
Did you know that there are all different kinds of student loans? Well, there are. In fact, when it comes to student loans you have lots of options, but all student loans break down into two main categories: federal loans and private loans. Speaking very generally, most students utilize private loans only when they have used up all available federal loans for a given year – although there are exceptions to this.
Federal student loans are loans that are made through funds given or insured by the federal government. Private student loans are loans that are made by private, non-government entities such as banks, credit unions, schools, or state agencies. Some of the benefits that federal loans offer are not available when a student takes out private loans, which is why most students use up all available federal funds before applying for private loans. However, for well-qualified borrowers or those with well-qualified cosigners, private loans might be a better deal when the interest rate offered on them is lower than the available federal interest rate. I’ll discuss this situation further when I discuss private student loans in more detail, below.
Federal Student Loans
Federal student loans are loans funded by the federal government. As mentioned above, most students deplete their available federal funding before they move on to private loans. That’s because federal loans have several benefits that don’t apply to private loans.
For instance, only federal loans can be consolidated into a Direct Consolidation Loan after graduation, which is an option that allows the borrower to consolidate all their federal loans into one and make just one monthly payment instead of several. (However, a borrower can consolidate their many federal loans into one private loan as well.) And income-based repayment plans, which are heavily utilized by borrowers, are also only available for federal loans. An income-based repayment plan allows the borrower to make smaller monthly payments that are contingent upon the borrower’s yearly income. Federal loans also always have fixed interest rates, which are sometimes (but not in all cases) significantly lower than interest rates offered on private loans.
Another benefit to federal loans is when a borrower qualifies, based on year in school and income, for subsidized loans. In fact, all federal loans are either subsidized or unsubsidized. What is a subsidized loan? Good question! A subsidized loan is when the government pays the interest on your loan for you.
For instance, if you borrowed $1,000 and had a 5% interest rate, twelve months after you first took out that loan you would owe $1,000 in principal plus $50 in interest. But if that loan was a subsidized federal loan, the government would pay that $50 as long as you are enrolled at least half-time in school. The government also pays the interest in certain other situations, such as when the loan is deferred or in a grace period.
Most borrowers take out significantly more than $1,000 in unsubsidized loans, and stay in school for longer than a year, so the subsidized loan program results in a substantial benefit to many borrowers. But this is a benefit only available to certain borrowers based upon their income, and only available for federal loans.
So far, we’ve discussed several advantages that federal loans have over private loans, including subsidized loans, fixed lower interest rates, and flexible repayment plans. There are a few other important benefits to federal student loans, such as:
· Most federal loans do not require a credit check – which means borrowers with bad credit or no credit still qualify!
· If a borrower falls on hard times, such as loss of job or becoming disabled, the federal government offers loan forbearance options.
· Federal loans don’t have to be repaid while the borrower is enrolled in school at least half-time; the loan payments are deferred during this period, and repayment begins only after the deferment period and grace period end.
· Depending upon when the borrower started school and what field the borrower works in after school, federal loans might be completely forgiven in 25, 20, or even as little as 10 years after repayment begins.
Next, let’s take a look at the different federal loan programs.
Stafford (Direct) Loans
Stafford Loans, also referred to as Direct Loans, can be either subsidized or unsubsidized. Often a borrower will receive a subsidized Stafford Loan up to the subsidized limit, and then additional funds that are also classified as a Stafford Loan but of the unsubsidized variety.
Subsidized Stafford Loans are offered based upon a student demonstrating financial need sufficient to qualify. The borrowing limits for Stafford Loans depend upon the year in school for which the borrower is classified. For instance, a student classified as a senior will have a higher borrowing limit for Stafford Loans than a student classified as a sophomore.
As of July 1, 2012, subsidized Stafford Loans are no longer available for graduate and professional students. The limit on both subsidized and unsubsidized Stafford Loans that any given borrower can receive in an academic year are based upon two factors: whether the borrower is classified as a dependent or independent student, and what year the borrower is in school (freshman, senior, professional school, etc.). Remember, while graduate and professional students can receive unsubsidized Stafford Loans up to their yearly limit, those students no longer qualify for subsidized Stafford Loans.
To see the current limits on yearly subsidized and unsubsidized Stafford Loans, go here: https://studentaid.ed.gov/sa/types/loans/subsidized-unsubsidized
Perkins Loans are another type of need-based student loans. Like Stafford Loans, Perkins Loans are subsidized and no payments are due as long as the borrower is enrolled at least half-time or in a grace period. Unlike Stafford Loans, when borrowing a Perkins Loan the school, and not the government, is the lender. However, the Perkins Loan program is still a federal program, and these loans will qualify for consolidation, deferment for hardship reasons, and loan forgiveness, the same way that Stafford Loans will.
PLUS Loans are special loans only available to graduate and professional students. Unlike Perkins Loans and Stafford Loans, where no credit check is performed, borrowers applying for PLUS Loans are subject to a credit check. However, there is no specific credit score required. Instead, the credit check is looking for adverse credit history. This means that if you fell behind on a credit card payment in the past, which dinged your credit score, this won’t prevent you from being eligible for PLUS Loans as long as you are now current.
However, if your credit report shows anything in collections at the time you apply, credit lines that are 90 days or more delinquent, recent foreclosure or bankruptcy, or other specific circumstances that constitute “adverse credit history,” you will likely need to get an “endorser” (essentially a cosigner) for your PLUS Loan. Your endorser’s credit report must be free of anything constituting adverse credit history. In certain situations, borrowers may be able to submit a letter of explanation detailing extenuating circumstances, along with sufficient documentation, and receive a PLUS Loan even with adverse credit history and no endorser.
Parent PLUS Loans
Parent PLUS Loans are student loans that a parent borrower takes out to pay for his or her child’s educational expenses. Only a parent can take out a Parent PLUS Loan, not the student themselves, and responsibility for the loan cannot be transferred to the student at a later time. The parent will always be responsible for repaying the loan. In order for a parent to be eligible to take out these types of loans, the student must be classified by the Department of Education as a dependent of the parent. Parent PLUS Loans require that the credit check (for the parent) come back free and clear of adverse credit history. The limit for these loans will be the cost of attendance minus any other aid that student receives, such as scholarships, grants, or other loans.
You can read even more about federal student loans, the different programs, and the different benefits and drawbacks, in my Federal Student Loans article.
Private Student Loans
I’ve talked a great deal about the many aspects of the federal student loan programs, and now it’s time to talk about how private student loans differ.
You already know that private student loans come from private institutions – e.g., banks, credit unions, and even companies best known for offering credit cards. Interest rates from private loan lenders tend to be higher than rates offered from the government, and the more favorable a borrower’s credit history the more likely it is that they will be offered a competitive rate.
For this reason, it’s very common for students applying for private student loans to use cosigners who have longer and better credit histories. Even with a cosigner, interest rates on private loans can get as high as the rates on many credit cards!
Another important way that private student loans differ from federal loans is that many private loans require the borrower to immediately start making monthly payments, even while still in school. Also, there are no private student loans that are subsidized. Even if the loan repayment does not start until after a borrower graduates or leaves schools, interest will accrue from the day the loan is taken out. Repayment options such as loan forgiveness and income-based repayment are rare or unheard of with private lenders.
That said, many borrowers take advantage of private student loans every year, and private loans play a significant role in helping students pay for their educational expenses. Sometimes, students turn to private lenders when they have maxed out their available federal loan aid and need to “fill the gap” with alternative loans.
Other times, a borrower with excellent credit may find a lower interest rate in the private student loan market than they can get with a federal loan. If a borrower takes out private student loans, it’s important to do the research into offers ahead of time and know what to expect as to interest rate and repayment obligations.
Learn even more about the benefits and drawbacks of utilizing private student loans in my Private Student Loans article.
How Do Student Loan Interest Rates Work?
What will you pay in interest on the student loans you take out? Well, that depends on many factors, such as what kind of federal student loans you qualify for, and whether you will need to take out private student loans. Interest rates can change from year to year or depending on your current credit rating.
What Are Interest Rates?
Interest is money paid from a borrower to a lender to compensate the lender for loaning the money. An interest rate is the cost for borrowing, expressed as a yearly percentage of the remaining balance of the loan. Calculating interest precisely can get tricky, especially if part of each payment is paying interest and part is paying down the principal balance. However, as an illustration, assume that on January 1st you borrowed $1,000 at an 8% interest rate and everything, principal and accrued interest, was due on December 31st. You would owe a total of $1,080 at the end of the year, because 8% of $1,000 is $80. When interest is compounded, as it is on some federal loans, it means that when a borrower doesn’t pay off the interest as it accrues then the interest is added to the principal balance of the loan. This means that eventually the borrower will pay interest on the previous unpaid interest, which adds up faster and means the borrower pays more money over the life of the loan.
Variable vs Fixed Interest Rates
A fixed interest rate is one that is determined at the start of a loan and will not change over the life of the loan. For instance, if you are offered a fixed 5% interest rate, you will always pay 5% interest on that loan until it is repaid. A variable interest rate is one that is subject to variation over the life of the loan and might rise or fall. Usually a variable interest rate is tied to an index, which means the rate may rise or fall depending upon how the economy is doing and what market conditions are. Sometimes variable interest rates are subject to variation each year and sometimes they are subject to variation each month – a borrower should carefully read the loan agreement to determine how often their interest rate is subject to change.
Variable interest rates are somewhat of a gamble, but have the possibility of saving a borrower money if interest rates fall in the future. Some of the factors to consider when deciding whether or not to take a variable interest rate are how long you intend to take to repay the loan and whether there is a prepayment penalty for refinancing the loan before it’s repaid. Sometimes variable interest loans can be refinanced to low fixed-rate loans if the rate rises too high, but the loan agreement provides for a prepayment penalty (a fee for paying the loan off too early) that makes refinancing more expensive than sticking with the original loan. Such a prepayment penalty will be outlined in the original loan agreement.
Current Student Loan Interest Rates
Federal student loans are always given at fixed interest rates. These rates are subject to change each academic year, and also vary based upon the specific loan program. However, the rate that is current when the loan is disbursed to the student will be set for the life of the loan and cannot be raised. So, while a student might borrow at a different rate the next year, the rate will rise or fall only for the new loan and rates on the previous loans will not change after they are disbursed. Congress sets the interest rates for federal student loans. The most recent rates for Stafford/Direct and PLUS loans disbursed between July 1, 2016, and June 30, 2017, are shown in the table below.
|Loan Type||Borrower Type||Interest Rate|
|PLUS and Parent PLUS||Parents and Graduate/Professional||6.3%|
Federal Perkins loans are always given at a 5% interest rate each year, although Congress has the power to change this in the future. You can read more about how fixed and variable interest rates work here.
How to Apply for Student Loans
Once you understand the different student loan options available, you’ll be ready to apply for those loans. The process of applying for federal loans is different than the process of applying for private loans. There is only one application process for federal loan eligibility, which is accomplished by filling out the FAFSA (Free Application for Student Aid) and submitting required tax information about yourself and, if you’re a dependent student, your parents as well. Private student loans require a separate loan application for each lender, and a little research into the eligibility requirements for each as well. Below are the processes for applying for both federal and private student loans.
How to Apply for Federal Student Loans
Applying for federal student loans is a relatively straightforward process that begins with filling out a FAFSA online. By completing one FAFSA, you will be notified of what loans you qualify for based upon year in school and your classification as either a dependent or independent student.
As mentioned, the first and most important step is to submit a timely FAFSA. The FAFSA is available online at https://fafsa.ed.gov. In previous years, the FAFSA application period opened up on January 1st of the same year in which the academic year began. In other words, the FAFSA for the 2014-2015 academic year was available starting January 1, 2014. However, starting with the 2017-2018 academic year the FAFSA is available three months earlier, on October 1st of the prior year.
This is important because many schools give out need-based scholarship funds and grants based upon the results of the FAFSA, and these forms of aid are limited. For those which are available on a first-come basis, which is most, the students who fill out FAFSA earliest have a better chance of nabbing the most free aid money.
You might be wondering about my mention of tax returns and how to possibly submit tax information that far in advance. The answer is that the relevant tax year for each FAFSA will now be the tax year two years behind the academic year. For example, if you want to apply for aid for the 2017-2018 academic year, the FAFSA application period opened on October 1st, 2016, and the tax return information you will need to submit will be for 2015.
When you submit your FAFSA you will also list the names of schools you have applied to or will be applying to for that academic year. Any school that sends you notice of admission will also let you know at that time if they are offering you any scholarships or grants, and in what amounts. This allows you to compare offers from multiple schools. When you choose a school to attend, your school’s financial aid office will disburse what’s known as a “student loan refund” to you either by mailing you a check or depositing the funds into your bank account. This disbursement might happen a few days before or after classes begin. The disbursement may consist of a mixture of scholarships, grants, and federal student loans.
What Types of Loans Will You Get?
The types of loans you will be offered depend in large part upon the extent of your need and both your year in school and dependent/independent classification by the Department of Education. You may end up being offered both Perkins and Stafford/Direct Loans. Subsidized Stafford Loans are limited, and you will be offered a subsidized loan amount up to the limit before being offered funds that are unsubsidized. Generally, a student maxes out their eligibility for Stafford and Perkins Loans before either PLUS or Parent PLUS Loans are used. In part this is because the interest rate on PLUS Loans are higher.
How to Apply for Private Student Loans
You will likely only want to apply for private student loans if you have financial need that is unmet by the federal loans you’ve been awarded. Some students will prefer private student loans because of a lower interest rate, but this is relatively rare, and consideration should also be given to the difference in repayment and forgiveness options explained above in more detail. If you do decide to apply for private student loans, you will want to know about eligibility requirements, how to apply to lenders, and how to get your money once you’re approved.
Eligibility requirements for private lenders are much more strict than with the federal government. For starters, private lenders will most definitely run a credit check and take both your credit score and your overall credit history into account when deciding whether to offer you a loan and at what interest rate. Since many student borrowers have little or no credit history, it’s very common to use a cosigner for private student loans. Even if the student borrower can obtain a private loan on their own, using a cosigner with better credit will lead to a reduction in interest rate.
Applying for a private student loan with an individual lender will be much like applying for a personal loan or even a credit card, but the most important part of obtaining this type of loan takes place before you sign a loan agreement. The first step is to research as many financial institutions and companies offering private student loans as you can, and find one that offers you the best overall deal.
Don’t be misled by comparing interest rates alone – pay attention to other loan factors that will affect how you repay the loan. Check for prepayment penalties that would make refinancing more expensive, find out whether payments begin during school or after you are no longer enrolled, and ask what happens to your monthly payment obligation if you experience a financial crisis such as loss of a job or extended illness or disability. All of these factors are important.
Once you have identified a couple loan programs that offer terms you are comfortable with, it’s a matter of sitting down at your desk or computer and filling out the loan application. If you go through a bank or credit union, you may need to go to one of their branch locations to sign the documents. If you’re planning on using a cosigner, make sure that person comes with you – and make sure they are as aware as you are of all the important loan terms!
How to Get Your Money if Approved
If you are approved for a private student loan, your lender will let you know how and when to expect a disbursement. In contrast to federal loans, which are disbursed from your school, a private lender will likely deposit your funds into your bank account or send them to you in the form of a check. However, the lender will first require your school to confirm your current enrollment and that the private loan does not exceed the cost of your attendance after taking into account any grants, scholarships, and federal student loans you may be receiving.
Read more about applying for student loans here.
Repaying Your Student Loans
Most students don’t even begin to think about repaying their student loans until the day is almost upon them. But smart borrowers start to think and plan repayment options before they even take out that first loan. Read on to learn my best tips and advice for student loan repayment.
General Repayment Tips
Knowledge may be priceless, but higher education comes at the cost of even higher student loan payments for many borrowers. However, if you arm yourself ahead of time with all the information you need to make smart repayment decisions, you can pay down your student loan debt smarter and faster than your peers.
Paying Accrued Interest While in College
Most people don’t know that they have the option of paying the interest on their student loans while they’re still in school. Other students don’t realize why this might be important and save them thousands of dollars in interest later on. If some or all of your loans are unsubsidized, you should consider paying just the interest on your student loans while you’re in school.
If you can keep us with just the interest that accrues, and pay it off each month, you’ll graduate with the same loan balance you had when you began school – much like a subsidized loan. This doesn’t just save you from having to repay that interest later on. It also saves you from the financial hazard of compound interest, the nasty situation where interest is added to principal and the entire amount incurs more interest.
While you don’t have to pay anything towards your federal student loans until 6 to 9 months after you graduate, many students choose to pay the small monthly interest payments on their loans while they’re in school. It isn’t usually a lot of money, but even these small contributions of $50 or $100 per month can add up and mean that you pay much less interest over the long term and have smaller monthly payments after you graduate. If you want even more wisdom on how and why to pay interest while in school, check my Pay Interest On Student Loans While in School article.
Repaying Federal Student Loans
You have all kinds of options when it comes to repaying federal loans. Here are the most common.
· The Standard Plan: The standard plan is ten years of amortized payments, and is generally the shortest timespan for repayment – short of winning the lottery. If you’re serious about getting your debt paid off as quickly as possible, this plan will do that. You can also make as many additional and enlarged payments as you want, so it’s possible to pay off all of your debt in less than the ten years.
· The Graduated Plan: With the graduated plan, your payments are still amortized over the course of ten years, but they start off small and eventually become larger. The appeal of the graduated plan is that borrowers just beginning their career can take advantage of smaller payments to go with their smaller paychecks. Of course, with the graduated plan it is assumed that as you gain work experience your payments will rise, and that’s built into the plan itself.
· Extended Payment Plan: The extended payment plan is another option which allows you to make smaller payments, but this one extends payments for up to 25 years. Keep in mind that the tradeoff for smaller payments over a longer period of time is that you pay much more in interest.
· Income-Based Repayment Plan and Pay As You Earn Plan: These plans are both based upon your discretionary income. The plan(s) you qualify for will be based upon your income, number of dependents, and the year you started school. Once you graduate or leave school, your federal student loan servicer will be able to tell you which plans you qualify for and how much your monthly payment will be. These plans offer loan forgiveness after either 20 or 25 years of making payments – but be warned, as the laws stand now, borrowers who have loan debt forgiven under these types of plans will be hit with a significant tax bill based on the forgiven debt. And since payments made under these plans are sometimes less than the monthly accruing interest, it’s very possible that borrowers might ultimately end up with a tax bill that’s larger than their original loan balance!
Read more in my Paying Off Federal Student Loans article.
Repaying Private Student Loans
The terms of your repayment will depend upon the agreement you made with the lender when you first signed up. Some have grace periods much like federal loans, while others do not.
Private student loans will always start to accrue interest from the date they are taken out, which means that unless you’ve been paying the interest while in school, your balance upon graduating or leaving school will be larger than it was when you borrowed. What’s more, the interest that goes unpaid is usually compounded and that causes the loan balance to rise even higher.
Read more in my Paying Off Private Student Loans article.
Consolidating Your Federal Student Loans
A benefit to federal student loans is that they can be consolidated into a Direct Consolidation Loan. Read on to find out the benefits and drawbacks to consolidating.
How it Works
You can apply for a Direct Consolidation Loan on the government website studentloan.gov, either by printing and mailing an application or by completing the application online. You can also ask your student loan servicer to help you when drafting and submitting your application. If you want to look into consolidating your federal loans into a private loan, you’ll want to shop around with private lenders much the same way as private student loans.
Consolidation, whether federal or private, gives you the benefit of having one monthly loan payment to keep track of instead of several. Your monthly payment might be less, as well. Even if you don’t consolidate all of your loans (for example, if you consolidate your federal loans but not private ones) you’ll have less monthly payments than before. You might save money if you can take higher interest loans and consolidate them into one loan with a lower average interest rate.
While consolidation might result in a lower monthly payment, one significant drawback is that most consolidated loans take longer to pay back, thus resulting in more interest paid over the life of the loan. This will cost you more money. In addition, you might lose benefits you originally had. If you consolidate federal loans into a private loan, your interest rate might improve but you could also lose access to special hardship programs later on. Learn more in my Student Loan Consolidation and Refinancing article.
Refinancing Your Student Loans
You can refinance your loans to a lower interest rate if you find a new lender who is willing to pay off your old lender and then offer you a better repayment deal. This option is usually only available to borrowers with very good credit or a cosigner with very good credit. Refinancing can save you thousands of dollars over the life of your loan.
Who is Eligible?
The borrowers who will be eligible for refinancing will be those with good to great credit history and those that find a qualifying cosigner. The process will be very similar to applying for private student loans, because this is essentially just repeating the process to get a better rate. At some point during the application process, the borrower and cosigner (if there is one) will be asked to provide credit history, which helps the lender decide how great of a risk the borrower is.
How to Apply
Applying for a refinance is going to be very similar to shopping around for a credit card, home loan, or even the original private student loans. Gather information online about available rates and application processes before actually filling out any applications. And before you shop around, check with your current lender to see if they would be willing to refinance you themselves. They may be willing to simply offer you a more competitive interest rate in order to keep your loan.
The best benefit to refinancing is easy – saving money on your interest rate! In addition to saving money, though, you might also be able to go from several monthly payments to just one, if you can find a lender willing to refinance several loans from different original lenders.
The most obvious drawback to refinancing student loans is when federal loans are refinanced privately. Although you may save on interest, be sure to understand what federal benefits you will be losing. Once a federal loan is refinanced by a private lender, the borrower can no longer put that loan into an income-based repayment plan. Also, that loan will no longer qualify for federal loan forgiveness programs.
Read more in my Student Loan Refinance & Consolidation article.
Student Loan Deferment
Deferment of student loans is sometimes available with private lenders, but deferment opportunities are much more generous with federal loans. Student loan deferments allow you to pause payments under certain circumstances, such as when you’re enrolled in school, unemployed, or on deployment with the military. Read more in my Student Loan Deferment article.
Student Loan Forbearance
Student loans forbearance is for people who don’t qualify for deferment. It’s another way to pause your student loan payments but it has other criteria in order to qualify. Learn more in my Student Loan Forbearance article.
What Happens if You Default?
Defaulting on your student loans has terrible consequences for your credit report, and can prevent you from taking out additional student loans in the future for graduate or professional school. A default is also likely to lead to garnishment of your tax returns or wages. Learn more about what a default is and the many consequences in my Student Loan Default article.
Rehabilitate Your Student Loans
If you do end up defaulting, it’s important to rehabilitate your student loans in order to get back on track to paying back your loan and ensuring your default eventually comes off your credit report. Find some detailed instructions on how to fix your student loan default in my Student Loan Rehabilitation article.
I hope this article and the secondary articles linked into it have answered most or all of your questions regarding how student loans work. If not, feel free to ask additional questions in the comments. I’ll be happy to answer them!