Most college students will have to borrow one or more student loans before they graduate, because there aren’t enough government grants to cover all college costs. There are more than $100 billion in new student loans made each year and more than $1 trillion in student loan debt outstanding.
Given that most student loan debt is unavoidable, it is important for college students to understand how student loans work.
A loan is borrowed money that is repaid over the time. In addition to repaying the amount borrowed, most borrowers also have to pay a fee, called interest.
A student loan is used to pay for college costs.
Interest is a fee charged for the use of someone else’s money. It is typically charged once a month based on the unpaid loan balance. It is not a one-time fee, as some borrowers incorrectly assume.
The interest rate is expressed as a percentage of the loan balance. Most new student loans have fixed interest rates, which do not change over the life of the loan. A variable interest rate will change periodically, such as every month, quarter or year.
Student loans are available from many sources. Most new student loans and parent loans come from the federal government through the U.S. Department of Education’s Federal Direct Loan program. Other student and parent loans come from private lenders, such as banks and other financial institutions, state governments and colleges.
Generally, students should always borrow federal first, because federal student loans are cheaper, more available and have better repayment terms.
A loan limit specifies the maximum amount you can borrow. Some student loans allow you to borrow up to the full cost of college, reduced by the amount of the other student financial aid. Other student loans have lower fixed annual and cumulative loan limits.
Student loans may be good debt, because they are an investment in your future. But too much of a good thing can hurt you. So, borrow as little as you need, not as much as you can.
To apply for federal student loans, file the FAFSA (Free Application for Federal Student Aid). The loans will be obtained through the college’s financial aid office.
To apply for a private student loan, contact the lender.
Eligibility for most private student loans is based on the borrower’s credit. Most students do not have long enough or good enough of a credit history and will be required to apply with a creditworthy cosigner. A cosigner is a co-borrower, equally responsible for repaying the debt.
After the loan is approved, the borrower will need to sign a promissory note, which describes the terms and conditions of the loan, such as the interest rate and repayment options. For federal student loans, there is a Master Promissory Note (MPN), which lasts for up to ten years of continuous enrollment at a single college or university.
Federal student loan money is sent to the college financial aid office while private student loan funds are sent either to the borrower or to the college financial aid office. If the loan proceeds are received by the financial aid office, they will be applied to the college’s charges for tuition and fees, and also room and board if the student lives in college-controlled housing. Any money left over is refunded to the student to pay for books, supplies and other college-related costs.
After the student graduates or drops below half-time enrollment, the borrower will be required to start repaying his or her student loans. Most student loans offer a grace period, typically 6 months, before repayment begins.
Standard repayment on federal loans involves a 10-year repayment term with equal monthly loan payments. Federal loans also offer extended repayment, which has a longer repayment term, and income dependent repayment, which base the monthly payment on the borrower’s discretionary income. These repayment plans reduce the monthly payment by increasing the term of the loan.
The lender or the loan servicer will send the borrower a coupon book before the start of repayment. The borrower should send in each month’s payment with the correct coupon. Some lenders send borrowers statements instead of a coupon book. Borrowers can also sign up for auto-debit, where the monthly loan payment is automatically transferred from the borrower’s bank account to the lender. Some lenders provide borrowers with an interest rate reduction as an incentive to sign up for auto-debit and electronic billing.
If a borrower does not make a loan payment by the due date, they are considered to be delinquent. Late fees may be charged to delinquent borrowers.
If a borrower is very late with a loan payment – 120 days on private student loans and 360 days on federal student loans – the borrower will be in default. Bad things happen when a borrower is in default. For example, collection charges of up to 20% will be deducted from every payment after a borrower is in default on federal loans. The federal government may also seize up to 15% of the borrower’s wages and intercept federal and state income tax refunds.
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