How Student Loans Work - Money Under 30
Student loans make college--and, increasingly, a middle class life---possible. But you should understand how student loans work before taking them out.

Higher education is rapidly becoming a necessity. Degree holders have better odds in the job market, and the right degree is a great way to follow a passion and make yourself marketable at the same time.

Still, the costs of college and graduate school are only climbing upward. So what do you do?

You may be ready to join the 40 million Americans who have student loans. Borrowing to pay for an education may seem daunting, but borrowing can be affordable and manageable. Only you can decide whether loans are the best choice for you. Read the answers to these FAQ first.

What are student loans?

Student loans are sums of money you borrow for your education, and pay back over time—in most cases, with interest.

Loans will often be part of your financial aid offer from the school you attend. Look for grants and scholarships first, since those don’t have to be repaid. But if you don’t get a full ride, loans can make up the difference.

How do you apply for loans?

While you’re applying to school, you’ll fill out a FAFSA, or Free Application for Federal Student Aid. Pay attention to the FAFSA deadlines, which change each year. (For 2016, it’s October 1.) Usually, the FAFSA will be available starting in the fall for the next fall’s school year.

Applying for government loans

If you’re a dependent student, use your parents’ or guardians’ financial information. If you’re an independent student, use your own.

The federal student aid website has a forecaster tool, called FAFSA4caster, to predict what your expected contribution might be. Get together any federal tax information, bank statements, and pay stubs or employment info. You’ll need these documents for the application.

If you’re admitted to a program, your school will send a financial aid offer that may include federal loans (money loaned by the federal government).

Applying for private loans

Private loans (money loaned by a bank, a credit agency, or other organization) have a separate application process. You can compare private loans on sites like Credible. With Credible, you can enter some of your personal information and they’ll match you with a list of lenders that are likely to approve your application.

You should also check with direct lenders themselves.

One company, Stride Funding, offers ISAs (Income Share Agreements) that let you base your student loan payments on your income level. You can even pay nothing during months where you make less than Stride’s minimum income threshold of $3,333 per month ($40,000/year).

With Stride, you can opt for loan terms between 5-10 years. They also offer fixed rates as low as 2.0% per $10,000 in funding. That way, you can rely on a steady interest rate that won’t fluctuate.

Another great option is Ascent. Ascent is a unique lender because they offer a little more freedom when it comes to obtaining a loan. First of all, their application takes just a few minutes and consists of just four steps.

They also have a cosigner option if your credit isn’t high enough to qualify for a loan. And that cosigner can be released from your loan after you’ve made 24 consecutive, on-time payments (this isn’t an option with most other lenders).

With Ascent, you’ll get a fixed-rate for undergraduate loans between 3.39% - 14.50% and a variable rate between 2.46% - 12.98%. For graduate school loans, fixed rates are between 4.66% - 13.56% and variable rates are between 3.65% - 12.40%.

What types of loans are available?

In the U.S., there are two categories of loans: federal and private.

Federal loans

These loans are the most common. They’re offered by the federal government.

Before receiving federal loan funds, you will

  • Complete entrance counseling either in-person or online with a financial counselor. You’ll learn your rights and responsibilities as a borrower.
  • Sign a Promissory Note or Master Promissory Note. This is a legally binding document which lists the terms and conditions under which you will repay the loan. Keep a copy of this document! You’ll need it later.

Federal loans include:

Direct Subsidized Loans

With a subsidized loan, the government pays the interest while you’re in school and during any periods of deferment (“subsidizing” your education by offsetting the cost). Subsidized loans are available only to undergraduates with demonstrated financial need. The amount is capped to only cover your financial need, as determined by the FAFSA.

Direct Unsubsidized Loans

With an unsubsidized loan, the borrower is responsible for any interest that accrues when they’re in school and afterward. Unsubsidized loans are available to any undergraduate or graduate student. The amount is determined by the cost of attendance at your school and any other aid you’re receiving.

You may hear Direct Subsidized and Unsubsidized Loans referred to as Stafford Loans.

Direct PLUS Loans

These loans are available to graduate or professional students from the U.S. Department of Education. They require a credit check and decent credit history. The amount is intended to cover any expenses other aid does not.

Perkins Loans

These loans are for undergraduate and graduate students with exceptional financial need, borrowed directly from the school. Some schools offer Perkins Loans and some do not. The Perkins Loan program will expire after September 30, 2017. No new loans will be issued after that date.

Direct Consolidation Loans

If you have multiple federal loans, you can combine them into a single loan from a single servicer. The new loan is known as a Direct Consolidation Loan.

Some facts about federal loans:

  • In most cases, you won’t need a cosigner.
  • Unless you’re taking out a PLUS loan, you won’t need a credit check.
  • Interest rates are usually fixed (the same over the life of the loan).
  • Interest is tax-deductible.

Private Loans

Federal loans are your best option, since private loans offer much less flexibility.

Private student loans come from lenders not affiliated with the government, such as a bank, a credit union, a school, or a state organization. The amount you can take out and the options for repayment are up to the lender.

Some facts about private loans:

  • You may have to begin payments while still in school.
  • The loans may require a credit check and a cosigner.
  • Most private loan servicers will only quote you an interest rate after you apply, so it’s good to shop around.
  • The interest rates can be variable (fluctuating with the financial market). Some interest rates can be as high as 18% for private loans.
  • Interest might not be tax-deductible.

For in-depth questions about private loans (and for borrower advocacy), the Consumer Financial Protection Bureau has a private student loan ombudsman.

How much money can you borrow?


Perkins Loans

Student who have demonstrated exceptional financial need can borrow up to $5,500 a year until the program expires in September of 2017.

Direct Subsidized Loans and Direct Unsubsidized Loans

Students can borrow between $5,500 and $12,500 per year.

Grad students

Perkins Loans

Students who have demonstrated exceptional financial need can borrow up to $8,000 per year until the program expires in September of 2017.

Direct Unsubsidized Loans

Students can borrow up to $20,500 each year.

Direct PLUS Loans

The remainder of your college costs not covered by financial aid

How much should you borrow?

Just because you can borrow the maximum amount doesn’t mean you should.

The financial aid offer will estimate your living expenses, and you can turn down a loan or request a lower amount if you feel their estimate’s too high. Borrow only what you need. It’s a good idea to calculate your estimated living expenses yourself, with a cushion for the unexpected.

One rule of thumb is not to take out more loans than the anticipated first year’s salary in your field. Remember, you’ll still be expected to pay back the loan even if you can’t find work in your field, or your plans change.

Look at the terms and conditions of any loans you’re offered—such as the interest rates (lower is better) and the date when you’ll need to begin repayment.

How do interest rates work?

Remember calculating interest rates in middle or high school math classes? You don’t need to dust off your SAT prep book, but you should know how interest rates affect your loan before you borrow.

Interest is money paid to the lender at a particular rate in exchange for borrowing a larger sum. Interest rate is calculated as a percentage of your unpaid loan amount, also known as the principal amount (or principal). You are responsible for paying interest on any unsubsidized loans.

Federal loans

The interest rates for federal loans are fixed, meaning the rates won’t change over the life of the loan. The rates are determined by Congress.

  • Direct Subsidized and Unsubsidized Loans for undergraduates: 5.05%.
  • Direct Unsubsidized Loans for graduate and professional students: 6.6%.
  • Direct PLUS Loans: 7.6%.

Private loans

Private loan interest rates are determined by the lender. These rates may be fixed or variable. With a variable interest rate, the rate may change over the life of the loan.

How to calculate interest

To calculate the amount of interest that accrues, or accumulates, on your loan, divide the loan’s interest rate by 365.25—the number of days in the year, including Leap Year. This number is the interest rate factor, or the daily rate on your loan.

For instance, a loan with a 5% interest rate (.05 divided by 365.25) would have a daily rate of 0.00013689253.

You can use the interest rate factor to calculate how much interest accrues on your loan from month to month.

Use the daily interest formula:

Outstanding principal balance (how much of the loan remains unpaid) x the number of days since your last payment x the interest rate factor you figured out above = interest amount

An example

Say your unpaid student loan amount is $33,000—the average student debt amount for a graduate in 2014. It’s been 30 days since your last payment, and you have a 5% interest rate.

33,000 (unpaid principal) x 30 (days since last payment) x 0.00013689253 (interest rate factor)= about 135.5, or $135.50 in interest accrued that month.

You can also use our loan calculator to determine how much interest a given loan will accrue.

When and how do you pay loans back?

Repayment options are flexible (especially for federal loans), and can change as your life situation changes.

You can apply for deferment or forbearance—a period of time where you don’t have to pay back the loan—on federal loans and some private loans. If you have an unsubsidized loan, the interest will keep accumulating during deferment.

Paying back federal loans

If you have federal loans, you won’t need to pay them back while you’re in school at least half-time. You can start paying back early if you choose. There are no prepayment penalties.

After graduation, you’ll usually have a six-month grace period before your repayment schedule begins. Then your lender will ask you to choose a repayment option.

Each option requires you to pay a different amount per month. The more you can pay per month, the less you’ll pay overall.

Remember the daily interest formula above—if you make larger payments, you’re chipping away faster at the unpaid principal, which results in less accrued interest. By the same token, if you make smaller payments, you’re likely to pay more money overall, since the interest will add up.

The plans below apply to every federal loan except Perkins Loans. If you have a Perkins Loan, the school (your lender) should inform you about repayment options, which will vary.

Standard repayment plan

You pay a fixed monthly amount with the goal of paying your loan off in 10 years (30 years for a Direct Consolidation Loan, which tends to be larger). This option saves the most money overall, but costs more at a time.

Graduated Repayment Plan

You start out with smaller payments which increase every two years—again, with the goal of paying off the loan in 10 years.

Extended Repayment Plan

You pay monthly on a fixed or graduated plan with the goal of paying the loan in 25 years. This option is only available to loan holders with $33,000 or more in debt.

Income-Based Repayment Plan

Your payments are capped at 10% of your discretionary income. Discretionary income is the difference between your income and 150% of the poverty guidelines for your state and family size.

Income-Contingent Repayment Plan

You pay, monthly, either 20% of your discretionary income or the amount you’d pay monthly with a fixed payment over 12 years—whichever is less.

Income-Sensitive Repayment Plan

You make monthly payments based on your annual income for up to 15 years.

Federal Student Aid has a repayment estimator where you can plug in the amount of your loans, your interest rates, and your income to see what option might work best.

If you find you can’t afford your payments, get in touch with your loan servicer and see if you can switch to a more affordable plan. Nonpayment will hurt your credit and may eventually lead to default.

Paying back private loans

Before you take out a private loan, learn what repayment options you’ll have. Some private loans may require payment while you’re in school. Some will have more flexible repayment options than others. Some may allow deferment or forbearance, or be able to re-negotiate a high variable interest rate.


As tuition skyrockets, and a college degree becomes more necessary for a middle-class life, student loans play a bigger and bigger part in most people’s financial lives. Student loans can be scary, overwhelming, and painfully tedious to contemplate.

But knowing what you’re getting into—in terms of interest rates and repayment plans—can take some of the terror out of borrowing large sums to finance your future.

Read more

Related Tools

About the

Amy Bergen Writer
Total Articles: 89
Amy Bergen is a writer and editor based in Portland, Maine. She's interested in technology, literature, and how the world will change in the future. You can reach Amy at LinkedIn.

Article comments

We invite readers to respond with questions or comments. Comments may be held for moderation and will be published according to our comment policy. Comments are the opinions of their s; they do not represent the views or opinions of Money Under 30. Comments have not been reviewed or approved by any advertiser, nor are they reviewed, approved, or endorsed by our partners. It is not our partner’s responsibility to ensure all posts or questions are answered.
Deb says:

I’m curious what happens with loan repayment for college students who want to defer a year in the middle of their college experience at this time of COVID-19. I’m not a college student, just a curious HS teacher. I think there can be a lot of tricky scenarios and it’s worth organizing the facts for people if you could put together another article. I graduated college when the economy was a mess years ago and friends of mine are still paying loans, big loans, and they’re over 40. Don’t want to see something bad happen to current kids in college.

Connor says:

This was extremely helpful – Thank you very much!


Cancel reply