A digital calculator on a phone face which can be used when researching loans

College Success

What Are Student Loans & How Do They Work?

12.08.2022 • 12 min read

Nick Griffin

Subject Matter Expert

Learn what a student loan is, how it works, and the different student loan options. Also, read about repayment options and alternative ways to pay for college.

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In This Article

  1. What Are Student Loans?

  2. How Do Student Loans Actually Work?

  3. Student Loan Interest

  4. Federal Student Loans vs Private Loans

  5. 4 Types of Federal Student Loans

  6. Repayment Options

  7. Alternative Ways To Pay for College

Whether you are right out of high school or a working adult, going to college is a big decision.

Why? You have to figure out so much. Like what major will you choose? How will you organize your life around a new school schedule?

But one of the biggest questions is how will you pay for it all?

Student loans are one option. To cover at least part of their educational expenses, most students turn to student loans. Let's learn more about them before you consider this route.

What Are Student Loans?

Student loans are a type of financial aid used to pay for college expenses such as:

  • Tuition

  • Housing

  • Meal plans

Student loans are different from other types of financial aid like grants and scholarships. With student loans, any money that you borrow you have to pay back, with interest.

According to the Education Data Initiative, 65% of college graduates have student loan debt. The average college graduate currently owes around $40,000.

This may seem like a shocking number at first glance. What is important to think about is the value of a college education to you.

Each year, thousands of students take out student loans to help pay for college, and people successfully pay off their existing student loans every year.

Creating—and sticking to—a solid college budget while accessing other financial aid can help reduce the loan amount you need.

Before taking out any student loans, know how they work. Doing this will help you figure out how to manage your student loans and reduce what you pay back in the future.

How Do Student Loans Actually Work?

First, remember this one thing: student loans are only one form of financial aid. With financial aid, a student receives money to cover college expenses. The aid can be a mix of money that you must pay back and awarded money that you do not need to pay back.

Most financial aid is determined by filling out a FAFSA (Free Application for Federal Student Aid). The FAFSA is not time-consuming, but it is important to fill out the FAFSA correctly.

The FAFSA compares the cost of the higher education program you plan on attending to the amount of income you, or your family, have available to pay for college.

By comparing the cost of attendance (COA) to the expected family contribution (EFC), the federal government will know how much money a student needs to pay for college. Students must fill out the FAFSA each year because income levels change.

It is the FAFSA that determines if students qualify for any federal grants or work-study programs, and how much they receive in student loans.

Once the student accepts the loan by signing their master promissory note (MPN), the lender releases funds to the college to pay for expenses.

The school will divide up the loan amount by semester, based on the student’s chosen preferences. It will disburse additional funds over and above school expenses to the student for use on other college costs.

With all federal loans and most private loans, students are not required to begin paying back their loans until after they graduate. The balance of your loan will include interest that has accumulated so far and the principal—the amount you took in loans.

Dr. Kelly Richmond Pope—Outlier's instructor for Intro to Financial Accounting—gives us a powerful overview of loans and interest rates. (This clip is from Outlier's free College Success course.)

TIP: You can get more expert advice and practical tips every college student should know in Outlier’s FREE College Success course.

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Student Loan Interest

If you understand how loan interest works, you will be better prepared to take out the best loan for your needs. Let’s start by defining it.

Interest is payment from you to a lender that is above repayment of the principal sum. In other words, it is a charge for borrowing the money, generally expressed as a percentage.

This interest can be determined by many factors—your credit score, the amount of the loan, the term (length) of the loan—and can be paid either while in school or after you graduate.

The interest rate of a loan is a percentage on your promissory note when the loan is taken out. The lender determines the percentage. This percentage will tell you how much money your loan amount increases based on your interest terms. These are different for federal loans than for private loans.

Must-Know Key Terms

You should know what the following key terms mean when looking at loan interest rates:

1. Interest Rate

The cost of taking out the loan charged by the lender.

2. Principal

The amount of money being borrowed.

3. Loan Term

The amount of time the borrower has to pay back the loan.

4. Variable Rate

An interest percentage that changes each month.

5. Origination Fee

A one-time fee that is charged when you first take out the loan.

6. Grace Period

Time when no student loan payment is required.

Federal Loan Interest

With federal loans, the government sets a fixed interest rate. If you have a subsidized loan, it will not accrue interest until 6 months after you graduate. An unsubsidized loan will start accruing interest right away.

Any federal loan will eventually accrue interest once per year. The rates of that interest vary based on the type of loan.

TYPE OF FEDERAL LOANINTEREST RATE UNTIL 7/2023MAX PER YEAR
Direct Subsidized 4.99%$12,500
Direct Unsubsidized6.54%Undergrad $12,500; Graduate $20,500
Direct PLUS Loan7.54% $20,500
Direct ConsolidationAverage of current loans Total of federal loans

*Studentaid.gov

Private Loan Interest

With private student loans, there is no standard interest rate used by all financial institutions. It is best to do your own research to find out which financial institutions can provide the best rates on the private loans.

Besides higher fixed interest rates or variable rates, private loans usually accrue interest each month. This means your interest rates could double from one month to the next if you have a variable interest loan.

Federal Student Loans vs Private Loans

Students have the option of utilizing federal student loans, taken from the federal government, or private student loans, taken from financial institutions.

You should use federal student loans first because of their much lower interest rate. Private student loans can cover additional expenses after federal loans are exhausted.

Private loans differ from federal loans, but can still help pay for college. Often, students will take out loans from private lenders if their college costs are more than the federal loans, grants, and scholarships can cover.

FEDERAL STUDENT LOANSPRIVATE STUDENT LOANS
Enrollment must be at least half-timeAnyone is eligible
Borrowed from federal governmentBorrowed from bank or credit union
Lower fixed interest rateHigher or variable interest rate
Fill out a FAFSA to applyRun a credit check/may need a cosigner
Fixed maximum amountFlexible amount based on costs
Repayment starts 6 months after graduationRepayment can start the moment you take out the loan
Can qualify for federal loan forgivenessDoes not qualify for loan forgiveness

Several websites can help you find the best private loans to suit your needs. Eligibility for a private loan is based on a credit check or requires a co-signer if the student has poor or no credit.

With private loans, the interest rate is ‌higher on a fixed loan. While many financial institutions offer variable interest rate loans, avoid these because of their unpredictability.

It is important to remember that private loans rarely have limits on them the way federal loans do. The downside is that both interest and repayment can start from the moment you take out the loan. Meaning you must make payments while in school.

4 Types of Federal Student Loans

To help students pay for college, the federal government offers 4 types of loans. Each of these federal student loans uses the U.S. Department of Education as the loan servicer. Filling out a FAFSA will let you know which type of loan you qualify for.

1. Direct Subsidized Loans

The government grants subsidized loans to undergraduate students who exhibit financial need. Again, they compare your COA to your EFC.

If you receive a subsidized loan, the government will pay off the interest that accrues while you attend school and for a 6-month grace period after you graduate. This gives you time to find a good job before repayment starts and significantly cuts the amount of accrued loan interest you need to make monthly payments on.

Subsidized federal student loans should be the first student loan taken out by any college student.

2. Direct Unsubsidized Loans

An unsubsidized loan is a federal direct loan available to undergraduate and graduate students from all income levels. You do not need to prove your financial need to secure an unsubsidized loan.

If you receive an unsubsidized loan, you will start accruing interest right away. This means the government does not pay the interest for you. The interest rates of unsubsidized loans tend to be significantly lower than private loans since the federal government sets them.

Similar to subsidized loans, unsubsidized loans do not require payment until after your 6-month grace period after graduation from college. Seems great? The downside is you will have to pay back much more interest than subsidized loans.

3. Federal Direct PLUS Loans

PLUS loans are available to the parents of dependent students and to graduate or professional students.

Parent PLUS loans and Grad PLUS loans are the same type of loan. They have a higher interest rate than other federal loans, but the rates are usually still lower than the rates for private loans.

PLUS loans require a credit check, and borrowers with an adverse credit history or little credit history may be declined for a PLUS loan or may be required to provide a co-signer.

4. Federal Direct Consolidation Loans

Consolidation loans are very different. To consolidate means to combine. In this case, the government combined multiple loans into one.

Since the interest rate of federal loans is so much lower than private loans, the federal government gives lenders the option to consolidate all their federal loans. This ensures that borrowers keep their low federal interest rates.

Repayment Options

You can pay back student loans in several ways. Just remember that private and federal loans are different.

With private student loans, consult with your lender to explore the different student loan repayment options available to you.

Federal student loan borrowers have the following options for a repayment plan:

Standard Repayment Plan

For all borrowers, this plan begins 6 months after you graduate. The government divides the loan amount plus interest over a term of 10 years, and you make payments each month.

Income-Based Repayment (IBR)

Qualifying borrowers make monthly payments that equal a percentage (10% to 20%) based on their discretionary income—the amount left over after paying crucial bills. If you do not pay off the loan in 20 or 25 years, deepening your income, the remainder of the loan is forgiven. The percentage the borrower needs to pay and the terms are determined on an individual basis.

Income-Contingent Repayment (ICR)

The monthly payments are 20% of the qualifying borrower’s discretionary income. You make payments for 25 years. Any remaining loan balance is forgiven.

Pay As You Earn (PAYE)

Over 20 years, you make monthly payments that equal 10% of your discretionary income. It is guaranteed that you will never pay more than you would under the standard repayment plan. Any remaining balance after 20 years is forgiven.

Revised Pay As You Earn (REPAYE)

Similar to the PAYE payment plan, except that anyone can sign up. The terms of REPAYE are tied to your income, whether you are 20 or 25 years before forgiveness.

Alternative Ways To Pay for College

Student loans are a great resource. You can use them when needed to help pay for college. However, don’t rely solely on student loans.

With an abundance of financial aid available, students should look into several options to help pay for their college costs:

Apply for Scholarships

Scholarship money is free money that is given out based on merit—being especially good at something.

Each year, millions of dollars are available in college scholarships for those students willing to look. Many of these scholarships require a simple application and often an essay.

Scholarships come from many companies and nonprofits. Take the time to research scholarships and apply for them. They could save you thousands of dollars in student loan debt in the long run.

A great place to look for scholarships is through the college’s financial aid office.

Apply for Grants

Grants are different from scholarships in that they are needs-based. This means that grants are often given to those that have exceptional financial needs.

Several grants are available from federal and state governments. By filling out the FAFSA correctly, you can find out if you qualify for several grants.

Consider Alternative College Options

The idea of an education on a college campus may sound glamorous and fun, but it is not the only way to go to school.

With the access to online education that is available today, students can save thousands of dollars on coursework compared to a traditional university.

Consider Golden Gate University’s Degrees+ program powered by Outlier, where students can earn an associate degree from a top-notch university for a fraction of the cost of typical college tuition.

With the Degrees+ program, students learn through an interactive online platform designed to keep them engaged on their path toward success.

Find a College Job

It may seem like having even a part-time job in college can get in the way of your studies. But having a college job provides valuable and marketable skills you will use in your future.

By figuring out how to work while going to college, you can reduce the amount of money you need to borrow in student loans.

Of course, having a job in college is not easy and takes a lot of organization. Being able to do this shows future employers that you can manage your time effectively, be resourceful, and be willing to work hard.

Keep Your Expenses Low

Perhaps the most significant thing you can do to reduce your student loans is to manage your finances. Creating a college budget and sticking to it will ensure that your expenses are predictable—you can plan for them.

When you know how to manage your money, you can make crucial decisions that help you move toward having future financial freedom.

See if You Are Eligible for Loan Forgiveness

Many programs out there offer student loan forgiveness. Several public services—such as careers in education and health care—offer loan forgiveness programs that you may qualify for.

In exchange for employment in a specific field or location, these student loan programs will cover both the principal balance and any interest owed.

You can make room for your future by exploring alternative methods of college financial planning. While it is best to take out less in student loans, you should still access them when you need them.

Keep reminding yourself of why you want to get that degree or certificate and stay motivated. Whether you are going to school for professional development or in pursuit of a high-paying degree, the key is to focus on your goals and do the best you can with what you know.

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