Student loans can seem daunting at first, but they do not have to be. Spend some time learning about the student loan process so that you can make smart decisions about financing your education. Below, we provide a step-by-step guide to help you understand how do student loans work.
Applying for FAFSA
FAFSA stands for “Free Application for Federal Student Aid.” It determines your Estimated Family Contribution (EFC), looks at the Cost of Attendance (COA) based on your school, and then calculates your financial need. The financial need determines the maximum amount of need-based aid that you are eligible for.
To qualify for scholarships from your college, state grants, and federal financial aid like loans, grants, or work-study programs, you must file your FAFSA each year. You or your parents can file it online at the Federal Student Aid’s FAFSA website. A PDF version is also available if you would prefer to fill it out manually.
When to Apply for FAFSA
There are different FAFSA deadlines depending on where you live and where you want to go to school. This means you must keep track of at least three deadlines: federal, state, and school. Applying to more than one school? Write down each school’s FAFSA deadline so you do not miss out on need-based scholarships or aid. Contact your school’s financial aid office to find the correct due dates. The next federal FAFSA deadline is June 30, 2018.
FAFSA Filing Status
The FAFSA looks at an entire household’s income since the government assumes your parents will help cover college costs. For that reason, most students must file as dependents–even if their parents are not helping with school. This means that your entire household’s income and savings are all taken into account.
To file as a dependent (and most likely qualify for more financial aid), you must fall into at least one of the following categories:
- At least 24 on or prior to December 31 of the award year
- An orphan or ward of the court
- A veteran
- An active duty member of the U.S. Armed Forces
- An emancipated minor
- Homeless unaccompanied youth or at risk of being homeless during high school and within a year of filing
- Under the guardianship of someone other than your parent or stepparent
- A graduate or professional student
- Married
- Have legal dependents
- Attain a waiver for unusual circumstances for a financial aid administrator
What Information Do I Need to File a FAFSA?
Before filing your FAFSA, you will need your social security number, federal income tax returns, W-2s, records of other money earned, bank statements, records of investments, records of untaxed income, and an FSA ID. You will also need the same information (minus the SSN and FSA ID) for your parents as well.
Financial Aid Options Available
Federal student aid is broken down into two categories: need-based and non-need-based. Need-based federal student aid programs include the Federal Pell Grant, the Federal Supplemental Educational Opportunity Grant (FSEOG), Federal Work Study, Direct subsidized Loans, and Federal Perkins Loans. The amount of need-based aid you are eligible for is determined by subtracting your family’s estimated contribution from the cost of attendance. The amount left over is your estimated financial need.
Non-need based aid includes direct unsubsidized loans, federal PLUS loans, and Teacher Education Access for College and Higher Education (TEACH) Grant. The amount you qualify for is based on your COA and how much assistance you have already received. The amount of federal and non-federal assistance you are awarded cannot exceed the COA.
You can use the fafsa4caster to see how much aid you may qualify for without having to actually apply.
Interest Rates on Federal Loans
To understand how student loans work you must also understand how interest rates work. Federal loans come with pre-determined, fixed interest rates. These rates stay the same for the life of the loan. Federal student loans offer fixed interest rates that do not depend on the borrowers creditworthiness. Rates change based on congressional legislation.
| Loan Type | 2017-18 Interest Rate | 2016-17 Interest Rate | 2015-16 Interest Rate |
|---|---|---|---|
| Direct Subsidized Loans (Undergraduate) | 0.0445 | 0.0376 | 0.0429 |
| Direct Unsubsidized Loans (Undergraduate) | 0.0445 | 0.0376 | 0.0429 |
| Direct Unsubsidized Loans (Graduate) | 0.0600 | 0.0531 | 0.0584 |
| Direct PLUS Loans (Graduate and Parents) | 0.0700 | 0.0631 | 0.0684 |
In addition to interest rates, each loan comes with its own loan fee. This means that the amount of money you borrow is less than you actually receive. You must still pay back this amount however as part of your monthly payments.
Interest Rates on Private Student Loans
More often than not, your family’s EFC is not realistic. After exhausting federal student aid options, most students must borrow money from family or seek out private loans. Private loans come directly from a lender like a bank or credit union. You can find private loans with variable or fixed interest rates, and the rate you receive is highly dependent on your credit score. Since most students do not have good credit (or much of any credit), they typically need a parent to cosign.
On average, private student loans have higher interest rates than federal student loans. However, if you shop around and have a strong credit history, you could end up with as little as a 1.9% interest rate. Pay attention to whether the loan comes with a fixed or variable interest rate. Variable rates may seem more enticing at first, but the rate can change at any point–usually in the upward direction.
Obtaining your Student Loan Promissory Notes
After deciding on your loan options, the next step is signing your promissory note. Think of it like a binding contract. The promissory note lays out all terms and conditions of the loan and your rights and responsibilities as a borrower. This includes stipulations about when you defer payment or how you can receive loan forgiveness.
Federal Loan Promissory Notes
Direct subsidized and unsubsidized loans usually come with one Master Promissory Note (MPN). Signing the document affirms that you will pay back your lender for the full amount of the loan and interest. This single contract covers all of your eligible federal loans for 10 consecutive years. Make note that some schools may require separate MPNs each year. You must also sign an additional MPN for any Direct PLUS Loans that you borrow.
Private Loan Promissory Notes
Every private lender will have its own unique promissory note. The contract includes information about variable interest rates and the lender’s policy on repayment plans in cases of unemployment or hardship. Make note that some private lenders actually charge you a fee if you pay off your loan early, know as a prepayment fee. Read through everything carefully before signing.
Student Loan Repayment
The next step in understanding how do student loans work requires looking at student loan repayment. While you are at least a half-time student, you will not need to make any monthly loan payments. However, it is beneficial to pay off accumulated interest as soon as possible. Monthly payments will begin once your grace period ends.
Student Loan Grace Periods
The grace period is a set time during which you do not have to make payments. It begins the day of graduation or the day you drop below half-time enrollment status. Direct subsidized/unsubsidized loans and subsidized/unsubsidized Federal Stafford loans have a six-month grace period. PLUS loans have no grace period. Ask your college about the grace period for Federal Perkins Loans.
Paying off accruing interest during your grace period will make monthly payments more manageable.
Where Do I Make the Payments?
You can make either electronic or paper payments to your student loan servicer. Log into your FSA account to find your servicer. Options include receiving your statement electronically; paying with electronic debiting; scheduling a recurring debit; or mailing payments directly to your servicer.
Contact your private lender or visit their website to learn their preferred method of repayment. Most will offer online and postal mail options. Some private lenders will even slightly reduce your interest rate if you set up automatic payments.
Private Student Loan Repayment Options
Private lenders do not usually offer repayment options. Instead, every borrower pays the monthly amount based on the loan term, amount, and interest. If you can demonstrate hardship, your lender may lower your monthly payments until you get back on your feet. This is not the norm, so avoid taking out private loans if you fear you will not be able to pay them back.
Federal Student Loan Repayment Options
During your grace period, it is important to decide on a federal loan repayment plan. All federal loans default to the Standard Repayment Plan. Under this plan, you will have a fixed monthly payment for a number of years which depend on the loan size and interest rate. This monthly cost presents a huge burden to many borrowers. To make paying off loans more manageable, the federal government offers several repayment plans. Each comes with its own specifications and qualification standards and some offer student loan forgiveness after a set number of years.
As a federal loan borrower, you could qualify for any of the following student loan repayment programs:
Graduated Income Repayment Plan: This plan is designed for borrowers in low-paying positions who expect to make more in the coming years. They start with lower payments that increase every two years for 10 years. The loan term is still 10 years, but borrowers end up paying more over the life of the loan than those who stuck to the standard repayment plan.
Extended Income Repayment Plan: Extending your loan term lets you make smaller, more manageable monthly payments. You can choose a new loan term of up to 25 years, but it is recommended to choose the shortest loan term you can manage. The longer the term, the more interest you will pay.
Pay As You Earn (PAYE): PAYE helps borrowers who can demonstrate partial financial hardship. It caps monthly loan payments at 10% of your discretionary income. Those who borrowed their first loan on or after October 1, 2007 and took out a direct loan after October 1, 2011 may be eligible for this program. Loan forgiveness takes place after 20 years for undergraduate loans and 25 years for graduate loans.
Revised Pay As You Earn (REPAYE): Designed for borrowers whose loans were ineligible for PAYE, REPAYE caps your monthly payments at 10% of your discretionary income. This makes it a great option for anyone who has a high income and a lot of student debt. REPAYE also forgives undergraduate loans after 20 years and graduate school loans after 25 years.
Income-Based Repayment (IBR): This plan bases monthly payments on your income and family size, not on how much money you owe. You will owe no higher than 10% of your discretionary income if you were a new borrower on or after July 1, 2014 and receive forgiveness after 20 years. You owe no more than 15% of your discretionary income if you had loans prior to July 1, 2014 and receive forgiveness after 25 years. Many borrowers end up owing $0 each month.
Income Contingent Repayment Plan (ICR): The ICR restructures your loan payments over a 25-year term. This plan calculates your monthly payment in two ways. The first takes 20% of your discretionary income and divides it by 12. The second calculates “what you would pay on a repayment plan with a fixed payment over the course of 12 years, adjusted according to your income.” You pay the lesser of the two numbers. Forgiveness is granted after 25 years.
Student Loan Forgiveness Options
Aside from the programs above, the government also has a few additional programs that grant student loan forgiveness.
Public Service Loan Forgiveness: Under this program, borrowers who work in the public sector can have their loans forgiven after 10 years of service. To qualify, you must make 120 consecutive, qualifying payments. You must also have your loans enrolled in an income-based repayment program.
NURSE Corps Loan Repayment Program: Nurses who work in registered nurse shortage areas for a minimum of two years could have up to 60% of their student loans forgiven. Most states also offer their own student loan forgiveness programs for nurses. Check out our exhaustive list here.
Teacher Loan Forgiveness: Eligible teachers can receive a principal reduction of $5,000 to $17,500 on their loans. Plus, most will also qualify for full-forgiveness after 10 years under the PSLF program. At a minimum, you have to teach full-time for five consecutive years in a low-income school to be considered.
National Health Service Corps Loan Repayment Program: This federal program awards loan forgiveness to qualified health professionals who work in NHSC-approved Health Professional Shortage Areas for at least two years. Unlike the Public Service Loan Forgiveness program, not everyone who applies to NHSC is accepted.
Military College Loan Repayment Program: Congress created the CLRP as a recruiting incentive. This program repays a specified amount of eligible college loans for qualifying new military members. Only enlisted personnel are eligible. Right now, the maximum repayment is $65,000, but it depends on which branch you join. The Coast Guard, Air Force Reserves, and the Marine Corps do no currently offer this program.
Total Permanent Disability Discharge: Individuals who can prove they are totally and permanently disabled are eligible for immediate student loan discharge. The burden of proof is high and relies on documentation from the Veterans Affairs Office, the Social Security Office, or your physician. You will not be taxed on the forgiven loan amount.
Keep in mind that everyone’s path to paying for college is different. The way student loans work for you may be far different from how they work for your roommate. How student loans work best for each person can vary greatly, and it’s important to assess your own situation.
Frequently Asked Questions on How Do Student Loans Work
How do you take out a student loan?
First, you must file your FAFSA. Once you receive your FAFSA, you can choose to accept all, part, or none of your available financial aid. This is where you would decide whether to take out federal loans. If you still need help covering costs, you may need to take out a private loan. Search online or talk to your bank or credit union to find the best rates. Apply in-person or online for a private student loan.
How do student loans affect your credit score?
Student loans can either greatly help or greatly hurt your credit score. It all depends on your payment history. If you continually make on-time payments, your credit score will improve. However, paying your loans off too quickly can actually lower your score. Your early payments decrease the amount of interest (or income) that a lender earns. Future lenders may decide to charge you higher interest for a shorter term to make it worth their while.
Delinquent student loans hurt your credit score the most. To avoid or resolve delinquency, apply for an income-driven repayment plan. Your credit score will start improving even if your new minimum payments are just a few dollars a month. Call your private lender to learn about their repayment options if you are having trouble making payments.
How does a student loan from a bank work?
Private student loans help cover college costs just like federal loans do. However, most private lenders are credit unions and banks. Unlike federal loans, private loans offer competitive interest rates. This means that interest rates are not the same across the board. Instead, private lenders weigh your credit score heavily when deciding on an interest rate. This gives you more power to shop around and find the best rate.
Private student loans are also more restrictive than federal loans. For example, private lenders do not usually offer income-based repayment plans, deferment due to hardship or unemployment, or loan forgiveness. In nearly all cases, you must also start paying interest upon loan disbursement.
How much will I get for the student loan?
The amount you get depends on a few factors. For one, your total federal aid package (which includes federal loans) cannot exceed your college’s estimated Cost of Attendance. The maximum amount of federal dollars you can borrow for your degree is as follows:
- $31,000 in Stafford loans for dependent undergraduates
- $57,000 in Stafford loans for independent undergraduates
- $138,500 in Stafford loans for graduates/professional students
Two, it depends on where you take out your private loans. Some private lenders will only let you borrow the difference between your COA and financial aid package. Others simply have a yearly borrowing cap, making it easy to borrow much more than you need.
Can you use student loans to pay for rent?
Yes, you can. Student loans can cover any reasonable expense associated with college. These costs are grouped together and referred to as the Cost of Attendance and include things like housing, books, tuition, travel, and food. If you are living off-campus or renting an on-campus apartment, the estimated cost of rent will be factored into your COA.
Can Student Loans Be Forgiven?
Yes, student loans can be forgiven but you must meet specific qualifications. The three main programs that are available for federal student loans are the teacher loan forgiveness program, public service loan forgiveness program, and the disability discharge loan forgiveness program. Other than those three, there are many loan forgiveness programs for nurses, as well as loan forgiveness for financial hardships through the income-driven repayment plans.
