What are student loans and how do they work?

Since 1963, the cost of college tuition has increased more than 747% — a fact that makes it daunting to pay such costs entirely out of pocket from personal savings. Faced with the steep cost of higher education, many prospective students turn to student loans.

The latest data from the National Center for Education Statistics (NCES) found that about 30% of students borrowed federal loans for undergraduate school. NCES also reported that those who obtained federal student loans borrowed an average of $6,598.

Student loans can be a useful way to finance your degree. But before taking on thousands of dollars in debt, it’s important to understand what student loans are and how they work.

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What are student loans?

Student loans are a financial aid option designed to help cover the costs of higher education expenses. These loans are provided in a lump-sum and are repaid in installments. The debt must be paid back over an agreed timeline, plus interest (and fees, if applicable).

There are two main types of student loans: federal student loans and private student loans. Understanding the difference between these two types of loans is critical as each has its own pros and cons as well as its own eligibility requirements, rates and repayment terms.

How federal student loans work

Federal student loans function in many of the same ways as other types of personal loans. You are able to borrow money to cover the cost of college and the debt is repaid in installments at a later date with interest.

In the case of federal student loans, the funding is offered by the U.S. Department of Education and you will need to complete the Free Application for Federal Student Aid (FAFSA) in order to access the loans and determine whether you’re eligible for aid and exactly how much.

Your school will review your eligibility, and if it determines that you qualify for federal loans, it also calculates how much money you can borrow per school year.

Federal loans have annual and aggregate borrowing limits. However, you might not be offered the maximum amount, even if you qualify for a federal student loan.

“Depending on the student’s scholarship, grant and work-study aid, how much they can borrow may be restricted to an amount lower than the federal limit,” says Pam Sittig, director of financial aid at Grinnell College.

If awarded a federal loan as part of your financial aid, you can claim the full or partial amount that’s offered. The funds are disbursed directly to your school. 

There are various federal loan options — some designed for undergraduate students, while others are designed for graduate students and even the parents of dependent students. Some of these loans are available to students who demonstrate financial need on their FAFSA application, while others are not need-based. 

These options include:

• Direct Subsidized Loans: These are need-based student loans that are exclusively offered to undergraduate students. Interest on Direct Subsidized Loans that accrues during school, the grace period after graduation, and during deferment is paid by the government. 
• Direct Unsubsidized Loans: These loans aren’t based on need and are for undergraduates, and graduate- and professional-level students. Borrowers are responsible for all interest that accrues on this loan.
• Direct PLUS Loans: A loan that’s not based on need, Direct Plus funding is available to graduate and professional students (Graduate PLUS) and also to parents of dependent undergraduate students (Parent PLUS). Borrowers are responsible for all interest that accrues on this loan, and it’s the only federal loan that requires a credit check.
• Direct Consolidation Loans: This loan program allows borrowers to merge all of their existing federal student loans together into one single loan with one servicer.  

After leaving school, you’ll start making payments toward your loan, after a six-month grace period. The default repayment plan is 120 equal monthly payments over 10 years, but you can ask your loan servicer about other repayment plan options. 

How private student loans work

Private student loans aren’t beholden to the rules and procedures of federal student loans. This type of student loan is offered and funded by private financial institutions, such as traditional banks, credit unions, online institutions and schools.

Like other consumer loans, such as car loans and personal loans, a private student loan requires an established credit history. Lenders have different underwriting requirements that borrowers must meet to get loan approval.

If approved, a lump-sum disbursement might be sent directly to you or your school. Interest charges and installment payments typically start as soon as the funds are released. Some lenders allow you to defer your payments, however, while enrolled in school, but not all do. 

There’s no standardized rate or repayment period for private student loans, as lenders can set their own rates and terms. Some may have fixed interest rates, while others come with a variable rate. Additionally, private student loans don’t qualify for federal benefits, protections or programs such as student loan forgiveness.  

How to apply for student loans

The process for applying for student loans depends on the loan type you’re interested in.

Applying for federal student loans

You can complete the required FAFSA application online at StudentAid.gov, or submit a paper application by mail. To do so, you’ll need a variety of personal information, such as your date of birth, Social Security number or Alien Registration number, if you’re not a U.S. citizen. You’ll also need to provide financial information including federal tax returns for you and for your parents, if you’re a dependent.

The deadline for the FAFSA is on June 30th before the academic year for which you’re seeking aid. There might be other deadlines to know for state and school aid programs so confirm those dates in advance.

Before beginning the FAFSA application, it’s a good idea to create an account on the StudentAid.gov website. This will include an account username and password, which, combined, become your FSA ID. Establishing an FSA ID allows you to sign FAFSA forms electronically and helps eliminate any errors during the application process.

Applying for private student loans

For private loans, you can apply directly with the lender or partnering marketplace. You might be required to secure a co-signer for the loan. A co-signer takes legal financial responsibility for repaying the loan, if you are unable to make payments or default.

Before accepting a loan, shop around with a handful of private lenders. Compare interest rates, repayment terms, loan features and benefits to find one that’s best for you. 

Should you use student loans for school?

Student loans offer a lifeline for those who can’t afford to pay for school and other college-related expenses, out of pocket. Sittig notes that there are many reasons that students might want to borrow student loans, beyond the basic cost of tuition. 

“Other reasons to borrow include choosing to study abroad, choosing not to work so they can participate in multiple extracurricular activities, or choosing an unpaid internship,” says Sittig. “While borrowing should never be taken lightly, it can aid in providing experiences that contribute greatly to their overall educational experience, learning, growth, and thereby future earning potential.”

However, if not managed responsibly and repaid as agreed, student loans can balloon into a significant financial burden. It’s important to calculate the full cost of the loan and have a plan for repayment.

Alternatives to student loans

• Scholarships: These can be merit- or need-based financial aid that is not required to be paid back. Find scholarships through federal, state, city and local community sources, as well as businesses and nonprofit organizations.
• Grants: Grants are a form of gift aid for students who meet certain requirements. The key distinction is that this money does not need to be paid back. The federal Pell Grant Program, for example, is offered to undergraduates with exceptional financial need. You can find these opportunities through your state and local government, school, and private sources.
• Work-Study: A federal program that lets you earn federal aid through qualified part-time employment.

Lowering your college-related expenses is another way to reduce the amount of loans you need to obtain.

“If they can curb discretionary spending while in college, they can keep their borrowing to only necessities, which will lead to smaller student loan payments and more discretionary funds later,” says Sittig. She suggests students ask their financial aid office about budgeting and savings resources that can help make the cost of college more manageable.