Have you ever wondered how do student loans work?
Maybe you’re thinking about going to school and taking out a student loan, perhaps you are a parent trying to help your child find the best options, or perhaps you are about to start paying down your student loan debt.
Whatever your case may be, I am hoping today’s article will help you learn more about how student loans work, so that you can be prepared for your future.
There are just so many different components to student loans, and it can make it very confusing to understand how student loans work.
There are federal vs. private loans, you can pay them back in a variety of ways, and more.
Student loans are a big part of many people’s lives.
The average amount of student loan debt per borrower is $35,359 and 44.7 million people in the U.S. have student loan debt.
Not only that, but 10.8% of student loan debt is at least 90 days past due, and there is $96.1 billion in Parent PLUS student loan debt.
I’ve talked to lots of different people about student loans over the years, and many of them have borrowed more than they should have or made other decisions about their student loans that have negatively impacted their life for years to come.
Many of those people simply didn’t understand how student loans work.
This is why what I’m sharing with you today is so important. Student loans can follow you around for years, and your student loan debt can impact any other major life decisions you make, like buying a house, having kids, the job you get, retirement, and more.
Knowing how student loans work can help you make the best decisions when borrowing money for school and as you pay them back.
Some of the topics discussed in this article include:
- How do you get a student loan?
- What is FAFSA?
- What’s the difference between federal and private student loans?
- How does paying back student loans work?
- How does student loan forgiveness work?
- Should parents pay for college?
- Should parents cosign on student loans?
- How else can parents help their children?
- Should you refinance your student loans?
In today’s article, you will learn how student loans work so that you can approach student loan debt with as much knowledge as possible.
How do student loans work?
What is a student loan?
If you want to know how do student loans work, the first thing you need to know is exactly what student loans are.
A student loan is a money that is borrowed from the government or a bank to be used for college costs. Student loans may be used for tuition, dormitories (room and board), books, food, or other living expenses.
Student loans have to be paid back.
Before you take out a student loan, you should ask yourself questions such as:
- Will I be able to afford these student loan payments when they are due?
- What is the interest rate?
- When do my monthly student loan payments start?
- Does interest build on my student loans while I am in school?
I’m going to explain more about some of these questions in just a minute.
How do you get a student loan? How much do student loans give you?
How do you take out a student loan? How does getting a student loan work?
First, you will want to complete your FAFSA form, which is the Free Application For Federal Student Aid (I will be going more over FAFSA in the next section).
After you have submitted your FAFSA, your school will send you a financial aid offer, which may include student loans, grants, and scholarships. This letter will tell you how to obtain the loans mentioned in your financial aid offer. This will involve selecting the amount you want — you do not have to take the full amount offered, such as if you are able to pay for some of your tuition in cash.
In order to get the student loans you will also have to complete entrance counseling so that you understand your student loans, as well as sign and agree to the terms of the student loans.
When your student loan is approved, first your school will apply the loan funds to your tuition, fees, and dormitory/meal plan. Any money leftover will be returned to you.
I do not recommend taking out more than you need for school costs, as these will add up quickly over the years, and your student loans may explode without you even realizing it.
And, it is very common for your financial aid offer to list a higher student loan amount than what you actually need.
Content related to how student loans work:
What is FAFSA?
Like I said, FAFSA stands for Free Application For Federal Student Aid.
It is a form that is filled out by college students or those who are about to enter college to see if they qualify for financial aid.
After you fill out a FAFSA form and if you qualify for student financial aid, you may be rewarded with a grant, scholarships, loans, and/or a work-study program.
These different awards can help you pay for college.
Here are the FAFSA tips you need to know:
- To fill out your FAFSA, you should go to Studentaid.gov.
- Pay attention to FAFSA deadlines, which you can find here. Many don’t file their FAFSA on time. Yes, there is a deadline. You should make note of the deadline and try to submit your FAFSA way before the deadline.
- Many people make the mistake of not filing out their FAFSA at all. You must fill out your FAFSA if you want to qualify for any kind of money for school.
- You need to fill out your FAFSA every year that you attend school. It’s not a one and done type of form. Please, remember to do this each year. I recommend making a note on your phone calendar for the next several years so that you don’t forget.
- Collect the documents that you need to fill out your FAFSA form. To fill out your FAFSA, you will need your Social Security number, federal income tax returns, W2s, and asset information.
- Make sure everything is correct on your FAFSA form. Double, triple, or even quadruple check your name, address, Social Security number, tax information, and more. Errors can lead to delays in receiving financial aid!
- Make sure you contact your financial aid office at the college or university to see if there are any other forms you should fill out with your FAFSA. The financial aid office is there to help you, so do not hesitate to ask questions.
What should I know about student loans?
There are many things to research when you take out student loans or enter a repayment plan. Understanding your interest rates and payments can help you pay off your student loans faster and save money.
Here’s what you should understand about how student loans work:
- Your interest rate. Some student loans have fixed interest rates, whereas others might have variable rates. You’ll want to figure out what the interest rate on your loans are because that may impact the student loan repayment plan you decide on. For example, you might choose to pay off your student loans that have the highest interest rates first so that you can pay less money over time.
- What a monthly payment means. Many people believe that a monthly payment is all that you have to pay, are allowed to pay, or that by paying just the minimum monthly payment you won’t owe any interest. These three things are so incorrect! Even if you pay the minimum monthly payment, you will most likely still owe interest charges (unless your interest rate is 0% – but that is very unlikely with student loans).
- Student loan reimbursements. Some employers will give you money to put towards your student loans, but you should always do your research before assuming it’s just that simple. Some employers require that you work for them for a certain amount of time, you have great grades, good attendance, and they might have other requirements as well. There are many employers out there who will pay your student loans back (fully or partially), so definitely look into this option.
- Auto-payment plans. For most student loans, you can probably auto-pay them and receive a discount. Always look into this as you may be able to lower your interest rate by 0.25% on each of your student loans.
How do federal student loans work?
Federal student loans are offered by the U.S. Department of Education, and there are four types of direct loans available. These include:
- Direct Subsidized Loan – These are student loans for eligible undergraduate students who have financial need to pay for college.
- Direct Unsubsidized Loan – These are student loans for undergraduate, graduate, and professional students, but is not based on financial need.
- Direct PLUS Loans – These are student loans for graduate and professional students and parents of dependent undergraduate students. You do not need to show financial need for a Direct PLUS Loan, but a credit check is required.
- Direct Consolidation Loans – These are loans that allow you to combine all of your federal student loans into one loan with one loan servicer.
How do private student loans work?
You may find private student loans through a bank, credit union, or through the college you are going to. How student loans work through a private lender is much closer to how personal loans work.
Your payments may start while you are in school, you may need a cosigner, and your interest rate is sometimes higher than a federal student loan.
How does student loan interest work?
This is one thing many people don’t realize about how student loans work — your student loans may all have different interest rates. The interest rates on your loans depend on the kind of loan you take out and when you borrowed the money.
With Direct Subsidized Loans, the U.S. Department of Education pays the interest on your loan while you’re in school at least half-time, for the first 6 months after you leave school, and during a period of deferment.
This is different with Direct Unsubsidized Loans in that with Unsubsidized loans, you are responsible for paying the interest during all periods.
How does paying back student loans work?
Most student loans have a 6 month grace period where you don’t have to make your first payment until 6 months after you graduate or if you go to school less than half-time.
But, this all depends on the student loan, so you will want to make sure that you read the terms on your loan.
You’ll want to make sure that your loan servicer(s) has your current address, as you will be required to pay your monthly loan payment once it’s due. Your address may change over the years, so this is extremely important so that you do not forget to pay. I suggest knowing this information before you finish school so you are prepared.
Even though you may not have to pay back your student loans right away, that doesn’t mean you can’t.
You can start paying back your student loans early, and you can pay more than the minimum monthly payment as well. Doing this will help you to pay off your student loans more quickly and possibly save you money.
How does student loan forgiveness work?
Teachers, nurses, and government employees may be eligible for student loan forgiveness through a program called Public Service Loan Forgiveness (PSLF). It is only available for Direct Federal Student Loans, including Direct Plus and Direct Consolidation Loans.
To qualify, you must be working full-time, make 10 years of on-time monthly payments under a qualifying repayment program, which include:
- Income-Based Repayment Plan (IBR)
- Income-Contingent Repayment Plan (ICR)
- Pay As You Earn (PAYE)
- Revised Pay As You Earn (REPAYE)
You will have to certify your income and repayment plan every year, and PSLF does not apply to private student loans.
PSLF is one of the most confusing aspects of how student loans work, so I highly recommend that you contact your student loan servicer as soon as possible. They will explain exactly how to move forward with forgiveness.
Should parents pay for college?
Do you think parents should help pay for their children’s college education? Do you think parents should be required to pay for their children’s college education?
These are tough questions to ask and to answer, but they are very important when thinking about the ever increasing cost of higher education.
I’ve read countless stories of parents who have $200,000 in student loan debt for their children, and it’s that kind of debt that causes those parents to struggle financially, be unable to reach their retirement goals, etc. These parents end up drowning in debt because they just honestly want to help their children get through college. What they don’t realize, though, is that there are other ways to help your kids graduate from college.
Please don’t be one of the many parents paying for college simply because you think you have to. If you can truly afford it, then do whatever you want with your money.
With everything being said, I must admit that I am not a parent myself, and I understand that it is probably a difficult thing for parents to face.
I believe that parents should only fund their child’s college education if the parent is on track for retirement.
This is because there are multiple ways to pay for college (paying for it with cash, student loans, grants, scholarships, etc.), but there is only one way to fund your retirement.
Remember, you cannot take out a loan for your retirement!
Due to this, you should not wreck your retirement plans to help your children through college. You should analyze your financial situation and see if you are track for retirement to see if helping your children through college is possible.
If it’s not possible, be honest with yourself and your child. Ultimately, what motivates parents paying for college most of all is love for their children. There are many ways to support and show your children how much you love them, and it isn’t just paying for college.
You can learn more at Parents Paying For College – Is This A Good Idea?
Should parents cosign on student loans? How do student loans work for parents?
Here’s an interesting statistic: the default rate on student loan debt averages around 10%.
So, what does this mean? This means that if you cosign a student loan for your child and they default, you will be stuck with the bill. This is one thing I wish more parents knew about how student loans worked before they borrowed money to pay for their child’s tuition.
While you may think that you have a great relationship with your child, everything can change once money is in the mix. In my experience, not many things cause as much tension in family relationships as money does. I have heard of several people who had a falling out with their parents and actually purposely stopped paying their student loans because they knew that their parents would cave in and start paying for them.
Yes, this is a disgusting behavior, I know, but it does happen to some parents paying for college.
College, of course, can be very expensive, which means that many people take out student loans in order to simply “afford it.” Before you cosign on student loan debt and pay for your child’s college education, I hope you fully understand how student loans work and the consequences that can come from taking them out..
Learn more at Would you risk your relationship and finances to cosign?
How else can parents help their children?
If you cannot afford to pay for your child’s tuition while staying on track for retirement, or if you decide that you just do not want to pay for their college expenses, there are many other ways that you can help and support your kids while they are in school.
Some things you can do include:
- Emotionally support them. Emotional support means listening to their troubles, giving advice, and helping them come up with a solid financial and college plan. You don’t have to agree with what they’re doing, rather be there when you need them.
- Help your child understand personal finance. Teaching simple skills, such as creating a budget, will help your children greatly, not just in college but throughout their adult lives.
- Assist your child in learning how to make money. There are tons of ways to make extra money, and helping your children find ways to do so can help them avoid student loans and/or pay them back.
- Show your children affordable alternatives. Choosing the right college and the right course of study can be overwhelming for a young person fresh out of high school. For example, your child may only think they should go to an expensive private university, but explain more affordable alternatives, such as going to community college or a state university. These options aren’t any less valuable, and they might actually be better suited for your child’s needs. Also, help them learn about ways to cut college costs as well.
- Help your child apply for school and scholarships. Applying for college can feel confusing for kids, but helping them find schools and helping with the application process can make it easier. There are also numerous scholarships that your child may qualify for. Some may require them to write essays, whereas others are based on high school grades. It can take a little work to find which scholarships your child is eligible for, but finding scholarships will help them avoid as many student loans. Also, most scholarships take very little effort and are given away by the college itself, which makes it a no brainer to apply for them!
- Help your child in other ways. For some reason, there is this myth out there that parents paying for college have to pay for absolutely everything else too. Set limits instead of paying for their tuition, textbooks, food, dorm, car, and everything else. You might help by giving them emotional support, letting them stay in your home while they are in college, helping them find ways to save money for college, helping them cut their college expenses, paying for something smaller such as textbooks, and more.
- Set your child up with a personal finance tracker. Financial trackers and apps are great tools for young people to use to see how they are doing with their finances. Platforms like Personal Capital allow you to aggregate and track all of your financial accounts in one place. While your child might not use their retirement tracker yet, you can sign up too and see where you’re at for retirement. You can sign up for Personal Capital for free here.
Also, there are many great books that you can recommend to your children, such as: Student Loan Solution and Broke Millennial.
Should you refinance your student loans?
Student loan refinancing is when you apply for a new loan that is then used to pay off your other student loans.
This is usually a great option if you borrowed private student loans and your credit score is better now than when you originally took out your student loans.
By refinancing your student loans, you may qualify for better repayment terms, a lower interest rate, and more. This is great because it may help you pay off your student loans quicker.
The positives of refinancing student loans include:
- One monthly payment to simplify your finances
- Lower monthly payments
- Lower interest rates, and more
Companies, such as Credible (this is an affiliate link, and I recommend them), allow you to refinance your student loans. With refinancing, the average person can save thousands of dollars on their loan, and that’s incredible! You can save a lot of money with student loan refinancing, such as with Credible, especially if you have high interest federal or private loans.
Credible’s platform is similar to the way Expedia works for finding flights – with Credible, you simply search the available rates to find the best student loan rate for you. There is no service fee, no origination fee, and no prepayment penalty if you end up paying off your student loans faster.
To use Credible, it takes less than 10 minutes and just follow these steps:
- Fill out a quick simple form (2 mins) – It only takes one form to see the many different lender options.
- Choose an option you like (2 mins) – On Credible, you can easily compare the different lenders all in one place.
- Provide your loan details (3 mins) – After providing more information about yourself, it takes one business day to receive your finalized offer.
Before refinancing a federal student loan, though, you will want to think about different federal benefits that you may be giving up. You may give up income-based repayment plans, loan forgiveness for those who have certain public service jobs (including jobs at public schools, the military, Peace Corps, and more). By refinancing your federal student loans, you may be giving up any future options for these loan forgiveness programs.
However, keep in mind that by refinancing your student loans, you may receive lower monthly payments, lower interest rates, and more. This may help you pay off your debt much faster. For me, I didn’t qualify for any loan forgiveness, so refinancing would have definitely helped me if I knew about it back then.
What you should think about before you refinance a student loan.
Before you decide to refinance a student loan, I wanted to talk about what choices you have with handling your student loans.
- If you want to take advantage of deferment, loan forgiveness, or some other sort of federal student loan program, you may want to think twice before refinancing your federal student loans. For more information, I recommend reading USA Today’s article What careers can get you student loan forgiveness?
- Be careful with variable interest rates. While they may seem appealing at times, remember that your interest rate may fluctuate. If you currently have a variable rate, you may want to refinance into a fixed-rate, which can make refinancing a great decision for you.
- Refinancing your student loans may lead to increasing your loan term, which can lead to lower monthly payments. However, it can also lead to higher interest charges over the life of your loan.
- If your credit is better than it was when you first took out your student loans, you may be able to qualify for better terms and a better interest rate by refinancing your student loans. I recommend shopping around to see what you can get. Start out by checking out Credible!
What to know about student loan debt? Do student loans affect your credit score?
Here are just a few more important things to know about how student loans work, specifically debt.
You cannot get rid of student loan debt through bankruptcy. But unlike other kinds of loans, federal student loans do not have to be paid back by your estate if you die before they are paid in full. That is not the case for private student loans — these must be handled the same way as your mortgage, car loan, etc.
Your student loan debt can affect your credit score, and here’s how:
- On-time payments are good for your credit score, but late payments can have a negative impact.
- Defaulting on your student loans looks very bad on your credit report and can stay there for 7 years.
- Parent PLUS Loans show up on the parent’s credit report, not the students. Keep this in mind if you are taking loans out for your children.
How do student loans work? In summary
Understanding how student loans work is a very important part of borrowing money for school, and there is nothing wrong with borrowing money for school.
Most people simply don’t have enough cash saved to pay for school, and student loans make school more affordable. However, don’t forget that there are scholarships, less expensive schools, grants, and opportunities to make money to pay for school.
When you do need to borrow money from school, only take out what you actually need to borrow. Also, do your research to make sure you are borrowing money at the best rates — very important for private loans.
Your student loans will be with you for several years, so make sure you are making the smartest and most informed decision possible.
What else would you like to know about how student loans work?
*Statistics about student loan debt from Investopedia, Forbes, US Department of Education