Melissa Brock

Melissa Brock

Writer & Blogger

My name is Melissa and I’m a longtime admission professional, personal finance writer, editor  and parent of two (very!) busy kiddos. I couldn’t make it all happen without my husband, Steve.

I hatched my site because I’ve heard so many head-scratching questions from parents. I’ve journeyed in the footsteps of hundreds of families, trekked to dozens of college fairs and even weighed the (billions?) of college savings options for my own two kiddos.

Top Tips: How Do Student Loans Work?

by | Feb 18, 2020 | Financial aid and scholarships | 0 comments

Student loans stir up a media frenzy all the time.

Love ‘em or hate ‘em, they still enable your son or daughter to get a degree that can increase his or her earnings way, way into the future. So, how do student loans work in the easiest language possible? (Key words, right there!)

Here’s what you need to know, from interest rates to federal loan and private loan options. Let’s dig in and answer the big question: “How do student loans work?”

What’s a Student Loan?

Simply put, you borrow money and pay it back — that’s a student loan.

You can access student loans from various sources, including the federal government, private sources (like your hometown bank) and other organizations. Your kiddo must pay back the money he borrows — with interest. He must pay student loans back whether he graduates or not.

One more thing before I dive in. Many families get hung up on taking out loans. I get it. However, if a particular school is the right fit for your child and can deliver the results he or she wants or needs, consider taking out loans.

So, how do you know what type of student loan is best? Great question.

Types of Student Loans

For simplicity’s sake, let’s focus specifically on federal and private loans.

Federal Student Loans

Guess who your lender is when you borrow federal student loans? Yep, it’s the federal government — or to be specific, the U.S. Department of Education. You’ll find three types of federal loans created specifically for college-bound students:

  • Direct Unsubsidized and Subsidized loans
  • Direct PLUS loans: This includes Grad PLUS loans for graduate and professional students and Parent PLUS loans for parents of undergraduate students.

Federal student loans are more flexible than private student loans for several reasons:

  • No credit checks involved — with the exception of the Direct PLUS loan, which does require a credit check.
  • Income-driven repayment plans are an option in some cases, which means repayment is based on how much your student makes once he or she graduates from college. 
  • Repayment plans can change as needed.
  • Federal student loan interest rates are lower compared to private loans.

Private Student Loans

Where can you get a private loan?

A local bank, credit union or national bank are three primary options.

These loans can fill in the need gap after your student has exhausted these options, in order: Scholarships, grants, parent/student savings and federal student loans. Here are some fast facts about private student loans:

  • You’ll hear about two types of interest rates: fixed and variable interest rates. Fixed interest rates are just like they sound — they don’t change, so your monthly payments stay the same. Variable interest rates go up and down. 
  • You or your student can make interest-only or fixed payments while you’re in school.
  • Private loans often require a co-signer. This person is commonly you, the parent, or another relative. Students can qualify for a private loan without a co-signer, though that’s difficult to achieve. No matter who applies for the loan, you will need a good credit score and will need to show proof of income.

Finally, remember that co-signers are just as responsible for paying back loans. Have a conversation with your son or daughter about risk and how you’ll each repay the loan before you agree to take on a private loan.

What Are Interest Rates?

You pay interest to a lender in order to be able to borrow money. Interest is a percentage ofunpaid principal amount. Direct loans are daily interest loans, which means that interest accrues (accumulates) every single day.

The higher the interest rate, the more you’ll end up paying on a loan if you take the full loan term to pay it off. Subsidized and unsubsidized loans treat interest rates differently:

  • Subsidized loans: The government pays the interest while your student is in school at least half-time, for the first six months after he or she leaves school and during deferment. Deferment is when your child postpones loan payments.
  • Unsubsidized loans: The government does not pay the interest while your son or daughter is in school. 
Federal loan interest ratesPrivate loan interest rates
Interest rates are fixed and rates are also usually lower than those for private loans. Here are the current rates:

Direct Subsidized loans and Direct Unsubsidized loans for
undergraduates: 4.53%

Direct Unsubsidized loans
for graduate or professional students: 6.08%

Direct PLUS loans for parents and graduate or professional students: 7.08%
Can be variable or fixed; interest rates can be higher or lower than federal student loan rates.

How to Apply for Student Loans

Fill out the Free Application for Federal Student Aid (FAFSA) to get federal loans. To get private loans, you’ll need to fill out an application with individual financial institutions.

Shop around to find the right private student loan lender. You can also check with your child’s chosen school’s financial aid office to see whether it has a preferred lender list. Have a conversation with someone in the financial aid office of the community college, liberal arts college or university your child plans to attend!

Next, compare interest rates, payment terms and fees to find the most cost-effective loan that suits your student’s needs. Next, complete a full application once you decide on the right loan for you.

Key tip: Only apply for how much you need to borrow.

What’s the Max Amount You Can You Borrow?

Your son or daughter can’t borrow an unlimited amount of student loans. He or she can only borrow from $5,500 to $12,500 per year for federal subsidized and unsubsidized student loans as an undergraduate. This amount also depends on his or her year in school and whether you can claim your child as a dependent.

Private student loan limits vary by lender. Generally, the amount your student borrows can’t exceed the school’s total cost of attendance.

Pay Off Student Loans

One key to knowing the answer to the question, “How do student loans work?” is knowing how interest rates play into the picture. It’s never too early to start talking about how to handle student loans. High school is a great time to start!

Lots of fancy repayment options may present themselves once your child graduates — refinancing, consolidating, etc. Consider the Debt Avalanche Method of repaying student loans.

What’s the Debt Avalanche Method? Great question. Here’s a quick overview:

  1. First, make sure your child doesn’t consolidate the loans. Keep them separate. Your child’s interest rates will likely be a mix of low to high rates for federal and private loans.
  2. Next, your child should always make the minimum monthly payment on each loan.
  3. The Debt Avalanche Method means your child pays off student loan debt with the highest interest rate.
  4. Once that higher rate loan is paid off, pay off the loan with the next highest interest rate.
  5. Your child is finally done when the last payment is made on the lowest interest rate loan.

The Debt Snowball Method is also a great option for quick wins. Your child would pay the minimum balance on all loans, just like in the Debt Avalanche Method. Then, he or she would pay the smallest balance first. Next, tackle the next highest balance until the loans disappear. It’s a great way to get some instant gratification!

Get the Right Student Loans for Your Child’s Needs

Think you have a basic idea of how student loans work? I hope so!

Above all else, make sure you max out federal student loan borrowing before taking out private student loans. Federal loans have protections that private loans don’t, including income-driven repayment plans and loan forgiveness programs.

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