Hands using a calculator and paper to calculate student loans

College Success

How Do Student Loans Work?

12.27.2022 • 12 min read

Nick Griffin

Subject Matter Expert

Learn how student loans work, the different types, and how to apply for each of them. We’ll also answer the most common questions.

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In This Article

  1. What Is a Student Loan?

  2. 2 Types of Student Loans

  3. How To Apply For Student Loans

  4. Student Loans FAQs

  5. How To Start Getting Student Loans

With the current student loan debt in the U.S. reaching over $1.7 trillion, it’s no wonder that prospective students are hesitant to access student loans to pay for college.

The average American college student borrows around $40,000 dollars to fund their education. That’s a lot, right? Still, the vast majority find themselves in this situation.

While taking out student loans to pay for college is easy, many students do not understand financial aid. This confusion leads to feelings of doubt about the actual value of a college education.

By learning how student loans work, students can use loans as a tool to get the education they want and figure out the best way to reduce future debt.

What Is a Student Loan?

Student loans are one type of financial aid to help pay for college. Student loans differ from gift aid to help pay for school like grants and scholarships. With student loans, you are borrowing money you have to pay back with interest after graduation.

Student loans come from either the federal government or through private lenders like a bank or credit union. Think of student loans in the same way you would a car loan or a home loan. You get the money to buy what you need now and make payments later until you pay off the loan and interest.

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Student loans can pay for:

  • Tuition and fees

  • Room and board

  • Critical bills and living costs

  • Transportation costs

  • Educational expenses like books or a computer

Even though student loans come from either the federal government or a private institution, the loan money goes through your school. The school’s financial aid office will use the loan money to pay for your school bills first.

Then the school will pay any remaining loan money out to the student through disbursements. These can be used to pay for other expenses.

Student loans tend to have higher interest rates than most other loans since there is no collateral to borrow with. When taking out a car loan, the bank can seize the car if you do not make payments, since they technically own it. With a student loan, they cannot seize your education, so it’s a greater risk for the lender.

The student loan terms and student loan interest rates differ based on the type of loan you take out. It’s crucial to understand the types of loans to determine the right one for you.

2 Types of Student Loans

Two types of student loans exist: federal direct loans and private loans. Both loans offer several student loan options with different terms and interest rates.

While most students borrow federal loans, private loans can also be an advantage in the right circumstances.

Federal Student Loans

The U.S. Department of Education issues federal loans with interest rates set by the U.S. Congress. Because of this, federal loans typically have a lower interest rate than private loans. They even have lots of perks, such as federal loan forgiveness and a variety of repayment plans.

The types of federal student loans are:

Federal Direct Subsidized Loans

These are loans offered to undergraduate students with high financial needs. They offer the lowest interest rates which are subsidized while you are in school. This means that the government pays the interest for you until 6 months after you graduate.

Federal Direct Unsubsidized Loans

These are loans offered to any student—grad or undergrad—regardless of financial need. There is still a 6-month grace period before loan repayment needs to start. However, as unsubsidized loans, they accrue interest from the moment you start the loan, meaning they cost more in the long run.

Interest rates are higher with unsubsidized loans than subsidized loans. But they are still much lower than most private loans. It would be wise to make small interest payments on these loans while in school to reduce the total cost of the loan in the future.

Federal Direct PLUS Loans

PLUS stands for Parent Loan for Undergraduate Students. This is a loan that parents can take out from the government to pay for their children’s college education.

PLUS loans also exist for graduate students and professional students who need to borrow more money than subsidized and unsubsidized loans will cover.

Both Parent PLUS Loans and Graduate PLUS Loans are unsubsidized and start accruing interest right away. Even though these loans have the highest interest rate of any federal loan, they are often more affordable than private loans.

Private Student Loans

Private loans come from banks and credit unions. Students typically use them to cover additional expenses after taking out federal loans. Since many different financial institutions are out there, private loan rates and terms vary‌. It is important to research the best ones.

Another factor to consider when taking out private loans is that they are unsubsidized and do not qualify for programs like federal loan forgiveness, deferment, or federal loan consolidation. This means that anything you take out in private loans you will pay back with interest.

A crucial component to weigh out in your student loan decision is your credit score. Financial institutions will base a student loan’s interest rate on the borrower’s current credit. If the student has poor or no credit, then they need a cosigner for eligibility.

A cosigner is a person with good credit who agrees to pay the loan if the borrower defaults or doesn’t pay on the loan. This will give you a much better interest rate.

To compare, here are student loan amounts and interest rates for 2023:

STUDENT LOAN TYPEINTEREST RATEMAX AMOUNT
Federal Subsidized4.99%$12,500
Federal Unsubsidized6.54%$20,500
Federal PLUS7.54%Cost of attendance
Private LoansVaries - 3.39% to 14.98%Cost of attendance

*studentaid.gov

How To Apply For Student Loans

Since federal and private student loans come from different sources, the process to apply for them is not the same.

The best course of action is to apply for federal student loans first. This is because when you apply for federal student loans, you are also applying for federal grants—which give you free money to go to school.

As long as you are going to school at least half-time, you qualify for the federal loan program.

Applying for Federal Loans

1. Gather your financial information

To apply for federal student loans, you need to have your previous year’s tax information. In the application process, the Data Retrieval Tool (DRT) can do this for you, but make sure the information is correct. You will also want the financial information of any other person(s) living in your household.

2. Fill out the FAFSA (Free Application for Federal Student Aid)

The FAFSA will ask for your personal and financial information to determine how much federal aid you qualify for. This includes grants, work-study, and student loans.

It is critical to make sure you fill out the FAFSA correctly. Take your time and review the application before hitting submit.

3. Review your Student Aid Report (SAR)

Several days after submitting your FAFSA, you will receive an electronic Student Aid Report. This report shows the information you put on the FAFSA. Look over the report and if there are errors, make sure you fix them on the FAFSA website.

4. Determine how much you need in federal loans

The school or schools you put on the FAFSA will contact you about your financial aid package. Each school will be different since your aid is determined based on the cost of attendance (COA).

Review this information and decide how much you want to take out in student loans. You do this through the school’s website. By having a college budget figured out ahead of time, you will know exactly how much you need in student loans.

5. Fill out a FAFSA for each year you are in school

Since financial information and school costs change each year, you will have to reapply for federal aid. Make sure you remember to do this. The FAFSA opens in October for the following school year, beginning in the fall.

For example, if you are planning on going to school in the fall of 2025, you can fill out a FAFSA in October of 2024.

Applying for Private Student Loans

1. Research your loan options

While you can get a student loan from a local bank or credit union, it is wise to shop around online to find the best private loans. Multiple online financial institutions offer competitive student loan rates to students in every state and international students.

Look for student loans that have no origination fees and lower fixed interest rates. Most loan servicers will offer variable interest rates as well. You should avoid them since the interest could change monthly.

2. Apply for your loan

Fill out the application for your student loan through the financial institution of your choice. Many companies will run a soft credit check to see if you have sufficient credit to take out a student loan. This does not hurt your credit score.

3. Consider a cosigner

If your credit score is low—or you lack credit history—think of getting a cosigner. Earlier we learned this is someone with good credit. This person is someone willing to sign the promissory note for your loan.

If you do not make payments on your loan, this cosigner agrees to cover the loan costs. Usually, a cosigner is a student’s parent or guardian.

If you use a cosigner to get a better rate, talk to the financial institution about cosigner release programs. This is where the lender can remove the cosigner from the loan after a certain period of regular payments by the student borrower.

4. Accept your loan amount

The private loan lender will ask how much money you wish to take out. Look over your budget to see how much you need.

This money will then go to the school of your choice to cover college costs first. The remainder is then paid out to you in disbursements to pay for any additional expenses.

5. Reapply for financial aid

Similar to federal aid, private aid requires you to reapply each year. Some financial institutions have a streamlined process to do this but still require your approval. Be sure you understand all student loan repayment terms before signing for it.

Student Loans FAQs

When do you pay back student loans?

Student loan repayment starts once you graduate from college or once your student status drops below half-time. You can choose to make payments while you are in college if you are able.

For most student loans, there is a 6-month grace period after graduation before you have to pay your loans back. This is to give you time to find a good job.

How does student loan interest work?

Interest accrues on a student loan each month after you take out the loan. If you have subsidized loans, the interest does not begin accruing until 6 months after graduation.

Interest will accrue based on your loan balance and your interest rate. As time goes on, your loan balance rises if the interest goes unpaid. Each month, the lender will charge interest to that balance for the life of the loan.

Think of the ongoing equation as:

(Loan balance x interest) + loan balance = new balance

So, a loan balance of $10,000 with 5% interest would be: ($10,000 x .05) + $10,000 = $10,500

What can student loans be used for?

Student loan lenders state that student loans pay for the cost of attendance. This is a broad phrase to encompass anything that’s needed to go to college.

Tuition, fees, room and board, bills, transportation, books, and school supplies all fit into this category. Essentially, after the school takes the money that is owed to them, you can spend the rest of the funds in whatever way you need them.

This is where some students get into trouble with student loans. How so, you ask? They use the money to cover all their expenses instead of only their education. Don’t do this. Instead, think about getting a college job. This way you can earn the money you need for your daily expenses and save money on unnecessary student loans in the long run.

How do you reduce student loan costs?

You can reduce the amount of money you need to borrow in student loans in several ways. Some students even manage to work full-time and go to school full-time so they do not have to take out student loans at all.

Getting grants and scholarships is another way to help pay for college, earning you free money to cover your costs. In fact, over 75% of full-time undergraduate students earn grant or scholarship money.

After you graduate, you can pay off your loans with many federal student loan forgiveness programs. They forgive your loan in exchange for your working in public service or in a specific location.

These federal repayment options as well as refinancing can reduce your student loan payments to better suit your needs.

How To Start Getting Student Loans

Once you have decided to go to college, the best place to start is by filling out a FAFSA. This free application will tell you if you qualify for grants and work-study programs to help pay for school and how much money you can take out in loans.

Keep in mind that federal loans typically have lower interest rates and offer better perks than private loans. Taking out a loan to pay for higher education is a big decision, so be sure you understand all the loan terms.

Consider taking some classes at a community college or online to reduce your college costs. Programs like Golden Gate University's Degrees+ allow you to earn transferable credits at a fraction of the cost. By going into a bachelor's degree program with credits already, you will be a step ahead and have to take out less in loans.

Student loans have helped many people get a college degree that couldn’t have afforded it otherwise. By understanding how they work, you can set yourself up for a future in a good career with very little college debt.

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