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Home Ask Student Aid FAQ How do student loans work: what you need to know

How do student loans work: what you need to know

Most college students will have to borrow one or more student loans before they graduate. There are more than $100 billion in new student loans made each year and more than $1.6 trillion in student loan debt outstanding.

Given that, for many, student loan debt is unavoidable, it is important for college students to understand how student loans work.

What is a Student Loan?

A loan is borrowed money that is repaid over time. In addition to repaying the amount borrowed, most borrowers also have to pay a fee, called interest. This is in addition to the amount you borrowed, which is referred to as principal.

A student loan is used to pay for college costs.

What is Interest?

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 may change periodically, such as every month, quarter or year.

The lowest variable interest rates available are often lower than the lowest fixed interest rates, but fluctuations to the variable rate are difficult to predict. When the rate fluctuates, your payments may be affected, and may increase.

How Does Student Loan Interest Work?

This is one of best questions to ask because interest is the cost of your loan. A student loan could have a fixed or variable interest rate, and will assess interest with either a simple interest or compounding interest formula.

In general, federal student loans will use a simple daily interest. Check out our blog which provides the details of how interest is assessed.

Who Provides Student Loans?

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, generally available to a broader audience, and have better repayment terms.

How Much Can You Borrow?

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 financial aid received. Some student loans may have lower 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.

How Do You Apply for a Student Loan?

To apply for federal student loans, file the FAFSA® (Free Application for Federal Student Aid). The loans will be disbursed through your college’s financial aid office.

To apply for a private student loan, our recommended first step is to compare lenders. Once you have reviewed the various lender interest rates and benefits, and selected a lender, you can then apply. Many lenders offer an easy online application process.

Eligibility for most private student loans is based on the borrower’s credit. Most students do not have a long enough or robust enough credit history to borrow on their own without a creditworthy cosigner. A cosigner is a co-borrower, equally responsible for repaying the debt. For most students, this is often a parent or other family member.

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). Your MPN allows you to take out loans for ten years, as long as you are continuously enrolled at the same school. If you switch schools, you could be required to complete another MPN.

How Do You Get Student Loan Money?

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. Check out our blog for more information on student loan disbursement.

How Do You Repay a Student Loan?

After the student graduates or drops below half-time enrollment, the borrower will be required to start repaying his or her student loans. Federal student loans offer a grace period, typically six months, before repayment begins. Private student loans may also offer a grace period that may vary by lender.

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 bases the monthly payment on the borrower’s discretionary income. These repayment plans reduce the monthly payment by increasing the term of the loan. (i.e., you will pay less per month, but pay on the loan for a longer period of time.)

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. Auto-debit is also a great way to ensure you pay your bill on time every month.

What Happens If You Don't Repay Your Student Loans?

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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