How Do Student Loans Work?

A student loan is money borrowed to pay for higher education at a college or university. Just like any other loan, a student loan has to be repaid in full, in addition to any interest that has accumulated over time. Student loans can be borrowed from the government or private lenders and are usually used for paying tuition, room and board, books, or other university fees. 

While attending a college used to provide a path to better jobs and higher incomes, the disproportionate growth between the cost of education and wages has caused student loan debt to become the bane of student’s and parent’s financial freedom. Below, we’ll dive into the world of student loans, explain how they affect many people’s financial future, and provide a better option to help pay for education.

Types of Student Loans

Before getting into the question of “how do college loans work?”, we first need to talk about the types of student loans offered. In general, there are two types of loans available for students: federal or private. Some of the most noticeable differences between federal and private loans will be interest rates, the date interest starts to accrue, the amounts awarded, and the time period the student will have to pay the loan back. Here’s a look at federal and private student loans explained in more detail.

Federal Student Loans

These loans are offered through the government from the U.S. Department of Education. In order to qualify for federal student loans, you have to submit a Free Application for Federal Student Aid (FAFSA) yearly. This application is used to calculate your financial need and provide options to pay for your education. If you have a heavy financial need, it is possible to also receive grants or scholarships from FAFSA. Your financial need and the degree you’re paying for also determines what type of federal student loan you qualify for. Here are the three most common: 

  • Direct Subsidized Loans: If you choose to get a loan (which we don’t suggest doing), these loans may be the best option. They don’t start accruing interest until after you graduate unless you drop below 6 undergraduate credits a semester. This means that for the 2-4+ years you’re in school, the government will cover the interest. Direct subsidized loans are available to undergraduate students based on financial need. The amount awarded is based on your year in school and whether or not you’re a dependent of your parents. The current annual award amount is up to $5,500, depending on grade level.
  • Direct Unsubsidized Loans: This loan differs from subsidized loans because it begins accruing interest as soon as you receive it. Direct unsubsidized loans are available to undergraduate, graduate, and professional students and don’t take financial need into consideration. The current annual award amount is up to $20,500 (minus any subsidized amounts received for the same period), depending on grade level and dependency status.
  • Direct PLUS Loans: A Direct PLUS loan provides another loan option if you don’t receive any or not enough in subsidized or unsubsidized loans to cover the cost of education. These are available to graduate students, professional students, and parents of dependent undergraduate students. A credit check is also required to qualify for this loan. The current maximum amount for PLUS loans is the cost of university attendance minus any other financial aid received.

Private Student Loans

Private student loans are acquired through banks, credit unions, or other online lenders. Interest rates, borrower prerequisites, and loan amounts differ from lender to lender because they set their own requirements. This tends to make private loans more expensive with higher interest rates (i.e. if at all possible, AVOID these types of loans). If you still opt for a private loan; in general, the better your credit score, the better your rates and term agreements. Additionally, most students will need a cosigner to qualify for a private loan. 

How Does Student Loan Interest Work?

Interest can be a double-edged sword. When it’s working for you, you can add a lot more money to your pockets, but when it’s working against you, it can cost you way more than you originally thought.

Interest rates, loan repayment terms, and principal amounts can vary based on your type of loan and will determine how much interest you end up paying. A student loan principal balance is the original amount you took out for the loan, not including the interest that will accrue over time based on your interest rate.

With federal student loans, congress sets the student loan interest rates for each type of loan. The current interest rates for loans taken out before July 2021 are:

  • 2.75% for undergraduate direct subsidized and unsubsidized loans
  • 4.30% for graduate/professional direct unsubsidized loans
  • 5.30% for parent/graduate/professional direct PLUS loans

With private loans, interest rates can be 6-8% or higher (remember: your interest rate is tied to your credit, whether good or bad). Private interest rates also might not be fixed, meaning your loan interest rate can vary from year to year.

You’ll also want to look at the loan repayment term (how long you have to repay the student loan). For most federal student loans, the loan repayment is 10+ years, while private loans can vary widely based on your agreement.

Now for the scary calculation part. Let’s say you took out the nationwide loan average of $32,000 to pay for your college. Let’s also use the average fixed interest rate of 5% with a repayment term of 10 years. You’d be paying about $340 a month for 10 years, costing you just over $40,708 for the original $32,000 loan. Yikes. 

How Does Paying Back Student Loans Work?

If you’ve already taken out student loans or are thinking about doing so, keep in mind that you will very likely have to live with your student loan for the next 10 years at least, but possibly even longer, while you make monthly repayments. That’s a big commitment to make when you aren’t even guaranteed to see a return on your education investment. Here’s a look at what you’ll be getting into with repaying different types of student loans.

Repaying Federal Student Loans

Federal student loans usually consist of a standard loan repayment term of 10 years and don’t require monthly repayments until six months after your graduation date. There are also income-driven repayment plans which, however, can make loan repayment even worse. 

An income-based repayment plan or IBR is a government repayment plan where you file every year and based on your income, how many dependents you have, and other factors, the government assigns an amount they believe you can repay per month. Because of this, your payments will change over time based on the income you’re making. For example, let’s say you had a $145,000 student loan balance with a 6.8% interest rate on a 25-year income-based repayment plan. You might start out with a monthly payment of $43.16, then by year 4 it’s $200, year 11 it’s $500, year 18 it’s $1,000, etc., etc., etc. Not only is your monthly payment increasing over time, so is the student loan balance. What was a $145,000 loan is now an over $500,000 loan. Now let’s say that by year 25 the government forgives this $500,000 loan. The loan balance forgiven is now considered “income.” Surprise! You have an extra $500,000 of “income” that’s subject to income tax. This means you could have to pay 20% or more – let’s say $100,000 out of pocket to cover for your student loan “forgiveness.” How’s that for raising your blood pressure? Additionally, income-based repayment plans incentivize you to keep your income down in order to keep your monthly payments down. We don’t know how you feel about keeping your income low, but we like to see our clients’ income go up. 

Repaying Private Student Loans

Private student loans usually have a repayment loan term between five and 20 years. Not all, but some offer similar terms to federal loans like no repayment during school with a six-month grace period. Many private loans, though, start accruing interest even while you’re in school. With this type of loan, you’re at the mercy of the lenders as they make all of the rules from repayment amounts to forbearance options and more.

Refinancing Your Student Loans

It is possible to refinance student loans. Refinancing a student loan can decrease the interest rate and help to get the loan paid off quicker so you can put your money to better use. If you’re able to find a lender who can help you refinance for free, get a lower fixed interest rate, and a shorter loan repayment term, then it might be worth it!

Is It Worth It To Get a Student Loan?

If it is possible, try to avoid student loans altogether. In the 1980s, it was possible for a student to work part-time and make enough money to pay for their education. Nowadays, even if a student were to work full-time while going to school, it’s likely they still couldn’t make enough to cover education expenses. Until wages catch up to the astronomical increase of education, it might not be the best investment for yourself or your future. Not everyone has to have a degree to be a success in some lines of work. If you’re still questioning how student loans work, the answer is that they don’t necessarily help people get ahead faster financially.

Having a student loan isn’t a bad thing per se, but when a student loan has a hold of you it can be a very bad thing for your finances. It is possible to attend college without any student loans but it takes proper planning and discipline usually many years ahead of the first day of college.  If more students would take a gap year to rationally consider their options and the consequences of financing a college education instead of rushing into student loan debt right out of high school, we believe that many people would be in better financial shape than they are today.

For people who want to plan ahead for funding college expenses, we recommend watching this video to see how student loans can be used effectively without the negative financial consequences most students experience.

When people follow typical financial planning, their finances suffer. We help people develop a plan so they can keep more of the money they make, become wealthier, and have financial peace of mind.  If you want to know if we can help you, call the office at 702-660-7000 or schedule a complimentary appointment here.

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