How Student Loans Work

A student loan is borrowed money that must be repaid over time, usually with interest. It is not free money. The total amount repaid will exceed the amount borrowed in most circumstances, often by a significant amount. For example, every dollar borrowed will cost about two dollars by the time the student repays the debt, given the typical mix of interest rates and loan terms.

Looking for Loans

There are many lenders offering student loans. Lenders include the federal government, state governments, banks and non-bank financial institutions (including some colleges and universities). Loan terms, such as interest rates and fees, vary from lender to lender, so the student will have to shop around to compare loan terms and conditions, before choosing a student loan.

Getting a Student Loan

To get a loan, a student submits a loan application to a lender. The FAFSA (Free Application for Federal Student Aid) serves double duty as a loan application for federal education loans, not just as an application for student financial aid. Other lenders may have their own loan application forms.

The lender decides whether the student qualifies for the loan. Eligibility criteria can include the student’s enrollment status, degree program, year in school and college or university. Eligibility can also be based on the borrower’s credit history, credit scores, and debt-to-income ratios. Some borrowers will need a creditworthy cosigner to qualify for a student loan. Some student loans are school-certified, where the college’s financial aid office confirms the student’s enrollment and remaining loan eligibility.

Signing the Promissory Note

After the student is approved for the loan, he or she will sign a promissory note. A promissory note is a legal agreement in which the borrower promises to repay the debt. The promissory note specifies the terms and conditions of the loan, such as the interest rate, fees and repayment term.

The student may also have to undergo entrance counseling before being able to receive loan funds. Entrance counseling reviews the terms of the loan and emphasizes that student loans are debts that must be repaid, even if the student is dissatisfied with the quality of the education he or she receives.

Loan Disbursement

Soon after the student (and cosigner, if any) sign(s) the loan promissory “direct to consumer” or DTC loans, send the money directly to the student. These loans are less common because they have a higher fraud rate.)

After the loan funds are applied to certain direct college costs, such as tuition, fees, room and board, the credit balance is refunded (or disbursed) to the student to spend on other costs, such as textbooks.

Although the student signs a Statement of Educational Purpose on the FAFSA, agreeing to use the financial aid on college costs, there are no controls to ensure that the student spends the money on the intended purpose as opposed to gadgets, entertainment and eating out.

Repaying Student Loans

Eventually, the student will have to begin repaying his or her student loans.

Repayment on some student loans starts while the student is still enrolled in college. Repayment on other loans starts after the student graduates or drops below half-time enrollment, often with a 6- or 9-month grace period between the in-school and repayment periods.

The student may be required to undergo exit counseling before leaving school. Exit counseling provides the borrower with information about repayment options. It also collects contract information from the borrower, such as current and anticipated mailing addresses and the name of the borrower’s employer. Borrowers are responsible for ensuring that the lender has up-to-date contact information.

The lender may send the borrower a coupon book or periodic loan statements. A coupon book provides pieces of paper, called coupons, which specify the amount of the loan payment and where to send it. In most cases, the borrower will need to include the coupon with the payment to ensure that the payment is properly credited to the correct student loan. The borrower must send a payment on-time even if he or she has not received a coupon book or statement.

Loan Amortization

Loan amortization defines a schedule of periodic payments to pay down the principal balance on a loan. Part of each payment is applied to the interest that has accrued and the rest is applied to the principal balance. It takes several years before the loan payments start making a noticeable dent in the principal balance of the loan.

This table shows the monthly payments on a $10,000 loan with different interest rates and repayment terms. Note how the monthly payment increases with a higher interest rate and decreases with a longer repayment term.

Monthly Payments $10,000 Loan

Interest Rates
Loan Term 3% 4% 5% 6% 7% 8% 9%
10 Years $96.56 $101.25 $106.07 $111.02 $116.11 $121.33 $126.68
15 Years $69.06 $73.97 $79.08 $84.39 $89.88 $95.57 $101.43
20 Years $55.46 $60.60 $66.00 $71.64 $77.53 $83.64 $89.97
25 Years $47.42 $52.78 $58.46 $64.43 $70.68 $77.18 $83.92
30 Years $42.16 $47.74 $53.68 $59.96 $66.53 $73.38 $80.46

The next table shows the total principal and interest payments over the life of a $10,000 loan with different interest rates and repayment terms. Note how the total payments increase with a higher interest rate and/or a longer repayment term.

Total Payments $10,000 Loan

Interest Rates
Loan Term 3% 4% 5% 6% 7% 8% 9%
10 Years $11,587 $12,149 $12,728 $13,322 $13,933 $14,559 $15,201
15 Years $12,430 $13,314 $14,234 $15,189 $16,179 $17,202 $18,257
20 Years $13,310 $14,544 $15,839 $17,194 $18,607 $20,075 $21,593
25 Years $14,226 $15,835 $17,538 $19,329 $21,203 $23,154 $25,176
30 Years $15,178 $17,187 $19,326 $21,584 $23,951 $26,416 $28,966

The monthly payment and total payments increase in proportion to the amount borrowed. For example, the next table shows the total principal and interest payments for a $20,000 loan. Doubling the amount borrowed doubles the loan payments.

Total Payments $20,000 Loan

Interest Rates
Loan Term 3% 4% 5% 6% 7% 8% 9%
10 Years $23,175 $24,299 $25,456 $26,645 $27,866 $29,119 $30,402
15 Years $24,861 $26,629 $28,469 $30,379 $32,358 $34,403 $36,514
20 Years $26,621 $29,087 $31,678 $34,389 $37,214 $40149 $43,187
25 Years $28,453 $31,670 $35,075 $38,658 $42,407 $46,309 $50,352
30 Years $30,355 $34,374 $38,651 $43,168 $47,902 $52,831 $57,933

The next table shows the maximum amount that may be borrowed for a $250 monthly payment with various interest rates and repayment terms.

Maximum Debt $250/month

Interest Rates
Loan Term 3% 4% 5% 6% 7% 8% 9%
10 Years $25,890 $24,693 $23,570 $22,518 $21,532 $20,605 $19,735
15 Years $36,201 $33,798 $31,614 $29,626 $27,814 $26,160 $24,648
20 Years $45,078 $41,255 $37,881 $34,895 $32,246 $29,889 $27,786
25 Years $52,719 $47,363 $42,765 $38,802 $35,372 $32,391 $29,790
30 Years $59,297 $52,365 $46,570 $41,698 $37,577 $34,071 $31,070
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