How Do Student Loans Work

by Stanislav Lem on April 26, 2012

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Understanding Student Loans

A student loan is a sum of money that is borrowed for the purposes of financing education expenses and is expected to be repaid with the interest. There are different types of student loans available to both undergraduate and graduate (professional degree) students, and even to parents. In order to have a better understanding of how student loans work, it’s necessary to start with the most important definitions (e.g. what are student loans, interest rates and more).

Important Definitions

Loan: An arrangement in which a lender gives money to a borrower and the borrower agrees to repay the money along with the interest, at some future point(s) in time. A student loan is a loan designed for helping borrowers cover education expenses. The key point here is that it must be repaid with the interest (unlike grants and scholarships).

Lenders: The federal government, state agencies and private organizations (including banks and other financial institutions) who provide funding.

Types of loans: Generally, student loans can be divided into two main categories: federal loans offered by the federal government and private (alternative or non-federal) loans offered by leading loan lenders like Sallie Mae, Citi and others.

Interest: A charge for the borrowing money calculated as a percentage of the unpaid principal amount (loan amount) borrowed.

How Do Student Loans Work?

In general the process is simple: When you take out a student loan – you borrow money and have to repay it later with the interest. You also are responsible for the interest repaying. There are different rates available to borrowers depending on loan types and other factors. For instance, federal loans have lower rates than alternative options. If you’re thinking about loans as your primary funding source, the best strategy is to apply for college loans provided by the federal government first. They are safe, have lower fixed rates and appealing repayment plans (from 10 to 25 years).

Federal Student Loans

Federal education loans are loans offered by the federal government for student and parent borrowers at affordable rates. Some types of federal education loans are need-based (financial need is a requirement to qualify) and some are non-need-based. However as the main rule: borrowers can apply for federal loans (except Direct PLUS loans) with a bad, little or no credit history and without cosigners.

Types of loans. There are four main types of federal loans that include: Perkins loans (offered under Federal Perkins Loan Program) and Direct Stafford, PLUS and Consolidation loans (offered under Direct Loan Program).

  • Perkins loans are need-based low-interest (five percent) loans offered for both undergraduate and graduate students.
  • Stafford loans are loans offered by the federal government under Direct Loan Program (DLP) for both undergraduate and graduate students. There are two subtypes of these loans: Direct Subsidized and Direct Unsubsidized Stafford loans. Direct Subsidized Stafford loans are need-based loans available to students who demonstrate financial need. Direct Unsubsidized Stafford loans are not dealing with need-based criteria, almost each student is eligible.
  • PLUS loans are loans offered for graduate and professional degree students and parents of dependent undergraduate students. These loans are non-need-based meaning that borrowers have to have a good credit score or a cosigner.
  • Direct Consolidation loans allow borrowers to combine several federal student loans into one single loan with the new terms. Direct Stafford, PLUS and Consolidation loans are offered under Direct Loan Program and are considered as direct student loans.

How to apply. The application process starts from submitting the FAFSA form. The form is lengthy and contains a number of questions (more than a hundred) about students and their parents. However it’s vital to your success to submit it on time. The research shows that millions of students fail to do it for certain reasons. Read our article “The Top 3 Ways How to Blow Your FAFSA” to avoid these mistakes. All students who want to receive federal student aid that include federal loans, grants and work-study must apply by submitting the FAFSA. Read our federal student aid guide for more tips.

How to repay. Generally borrowers are offered five repayment plans to choose from allowing them to have from 10 to 25 years the repayment (borrowers of PLUS loans are limited to only three repayment plans). Borrowers of federal loans have a period of time (after graduation) when it’s not required to start making payments known as grace periods (except PLUS loans, only a six-month deferment is allowed under certain circumstances). So, it’s a huge advantage that should be used. In addition, there are options for postponing repayment (deferment, forbearance) for those who have trouble making payments. For more information about repaying federal and private student loans, please, read the article “How to Repay Your Student Loans“.

Private Student Loans

“How do private student loans work?” – the question you may be asking yourself. The answer is simple: private student loans work the same as any other loans. You borrow money for covering education expenses (e.g. tuition, books) and then you have to pay it back with the interest.

It’s important to note that private (alternative) loans are dealing with creditworthiness. So, borrowers always have to have a perfect credit history or a credit-worthy cosigner. With federal loans you are not required to have a credit history or a cosigner (except Direct PLUS loans) and that’s why they are more preferable.

Types. Private loan lenders offer various loan products designed for undergraduate, graduate/professional degree students and parent borrowers. Each loan has own specifics depending on a lender’s loan policy and other factors. For example, Sallie Mae offer six different types of loans. Read Sallie Mae student loans for more details.

How to apply. The application process is simpler in comparison with the federal loan applying. Students can visit the lender’s official website, choose the loan type and click the “apply” button.

How to repay. The repayment periods, rates and options for postponing payments are variable. For example, some lenders may have flexible repayment plans, competitive rates and deferment/forbearance options, others may offer only competitive rates. For more details, visit our loan repayment section.

More resources. For more information about private student loans, visit our loan lenders section where you can find what popular lenders like Sallie Mae, Wells Fargo can offer you.

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