Student Loans

How Do Student Loans Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

If you’re just beginning to figure out your college financing options, it helps to have an overview of student loan funding. By understanding the basics of student loans, the lenders that finance them and the process of getting and repaying a loan, you can make smart financial decisions about paying for your education.

Student Loan Basics

A loan is money that you borrow. There are all different kinds of loans, from mortgages that help you purchase a home to business loans that provide the money to get a new business off the ground or pay operating expenses during periods of growth.

Student loans are a specific type of loan. Rather than using the money to buy a house, finance a car, or operate a business, this loan is used to fund a college education. The borrower is generally a student, though in some cases, a parent or guardian may be the one securing the loan.

Student loans are only to be used for educational expenses. However, those expenses may include college tuition, room and board costs, textbooks, course materials and even living expenses.

A student loan allows you to start earning your college degree, even if you don’t have the tens of thousands of dollars that it costs per year to attend a four-year school. Due to the rapid rise in the cost of a college education over the past few decades, most students can’t realistically hope to work their way through college. While many students do get grants and scholarships that help them afford an education, these sources of funding are limited. For many students, student loans fill the crucial gap between the money they actually have and the amount they must pay to go to school.

In fact, 69 percent of graduating students have at least some student loan debt, according to U.S. News & World Report. The average amount of student loan debt for earning an undergraduate degree is nearly $30,000.

Because loans are borrowed money, they will need to be paid back. Often – though not always – you won’t have to begin paying back your student loans until after you complete your degree or stop attending school full-time. However, lenders don’t finance student loans out of the goodness of their hearts. When you repay these loans, you will be charged interest. The longer you take to pay back your loans, the more this interest will add up, and the more you will end up paying overall.

The prospect of taking out student loans, especially for a large amount of money, can seem daunting. However, not all debt is necessarily bad. Just as a company may need to take out a business loan to help it afford the operating changes needed to grow and thrive, you may need a student loan so you can earn a degree that will help you start a better career and earn a higher salary. Rest assured that many students who use student loans to finance their degree do complete school on time, get the job they were seeking and repay their student debt without a problem. If you do struggle to afford your student loan payments at any point, help is out there.

Lenders That Offer Student Loans

There are two main types of student loans available to borrowers: federal and private. In the case of federal student loans, the federal government acts as the lender. These loans are funded by the U.S. Department of Education and include all loans issued under the William D. Ford Federal Direct Loan (Direct Loan) Program and the Federal Perkins Loan Program. Private student loans, on the other hand, are funded by private companies such as banks and credit unions.

There are some key differences between federal and private student loans, Federal Student Aid reported. The process of getting a student loan differs depending on the lender. So do the terms of your loan, including your rights as a borrower and your options for repaying the loan. Generally, federal student loans are preferable to private student loans, because loans issued by the federal government offer borrowers more protections, lower interest rates and more options for loan repayment.

The Process of Getting a Federal Student Loan

How you go about getting a student loan depends on whether the loan you’re seeking is issued by a federal or private lender. Although some students end up requiring both kinds of loans, it’s typically in your best interests to begin funding your college education by applying for federal funding first.

To apply for a federal student loan, you will need to fill out the Free Application for Federal Student Aid (FAFSA). This form determines your eligibility not only for federal loans, but also for federal funding in the form of grants (need-based gift aid that you don’t have to pay back) and work-study opportunities (aid that you receive in exchange for working, often on campus). Some colleges and organizations also require students to complete the FAFSA in order to be eligible for scholarships, merit-based aid that you don’t have to repay back, so it’s a good idea to fill out this application even if you’re not sure you want to take out student loans.

You can complete the FAFSA online or by mail. On average, filling out the FAFSA takes under 25 minutes to complete, according to Federal Student Aid. While students often have until the end of June to fill out the application for the upcoming school year, it’s best to complete your FAFSA as early as possible. Certain states and colleges impose earlier deadlines on students, and some college funding is awarded on a first come, first served basis, according to U.S. News & World Report.

While filling out the FAFSA, you need to list any schools you are considering attending on the form. It’s okay if you haven’t made a final decision about where you want to study just yet. In fact, many students don’t decide on a college until after they have seen the financial aid packages they would receive at each of their prospective schools.

You don’t automatically receive student loan funding once you submit the FAFSA. First, the U.S. Department of Education must process your application. Sometime after you complete the form – typically within three days to three weeks – the federal government will send you a Student Aid Report that summarizes your FAFSA application. In the course of processing your FAFSA, the federal government will determine what your Expected Family Contribution (EFC) should be. Colleges use this figure to determine you much financial aid you need.

Remember how you had to list every school you were considering on the FAFSA? Each of those schools will receive information about your EFC from the U.S. Department of Education. The schools use their cost of attendance and your EFC to put together a customized financial aid package. You will receive an award letter that details your financial aid offer, either electronically or by mail, from each of your prospective schools.

Even once you are offered financial aid, you get to decide what funding to accept. Naturally, you want to accept gift aid that you don’t have to pay back, like grants and scholarships. You can choose whether to accept a student loan and how much of the available amount you would like to borrow. Remember that you must pay interest on any money you borrow, and accept only the amount you will actually need – but don’t forget to factor costs like living expenses and textbooks into this calculation.

Once you accept your federal student loans, you will have to go through entrance counseling, a mandatory educational program that outlines your rights and responsibilities with regards to the loans you are taking out as well as the resources available to you. Some schools require in-person entrance counseling, while others may allow you to complete your entrance counseling requirement online in as little as 30 minutes. In addition, you will have to sign a Master Promissory Note expressing your acceptance of and agreement to the terms of your federal student loan. Most students sign their Master Promissory Note electronically, though you may have the option to sign a paper version of this agreement.

Attaining Private Student Loans

If you’re not able to secure enough funding in the form of grants, scholarships, work-study funds and federal loans, you may need to seek out private student loans. Because private companies like banks are the ones lending out this money, they can set their own loan terms and develop their own application process.

Generally, though, getting approved for a private student loan is more difficult than attaining a federal student loan. Private lenders typically consider your credit score and credit history, which can make it difficult for students who haven’t yet had the chance to build up their credit. Often, private lenders require a parent or guardian with established credit to co-sign for the loan.

Repaying Student Loans

Often, getting student loans is the easy part. Repaying those loans may be more challenging.

When you have federal student loans, you don’t have to begin repaying your college debt until you stop being a full-time student – ideally, when you graduate with your degree. If you take on any private student loans, then you may need to start paying on your loans while you’re still in school. Make sure you understand when you will need to begin making payments before you accept any loan.

Interest payments are an important part of repaying your loans. Federal student loan interest rates are fixed, which means that they can’t change over the course of your loan repayment. Often, they are significantly lower than private student loans, which means you end up paying considerably less to borrow the money for college. On the other hand, private student loans sometimes come with a variable interest rate. While the interest rate may be low at one point in time, it could rise at any time – even to rates higher than 18 percent, Federal Student Aid reported.

Who exactly do you make your student loan payments to? In the case of private student loans, you would typically make payments to the same bank or credit union that lent you the money in the first place. If that bank underwent a merger or was acquired by another financial institution, then you would usually make your student loan payments out to the bank under its new name. On the other hand, federal student loan repayments don’t go directly to the U.S. Department of Education. Instead, the federal government assigns loans to a third-party loan servicer, a company that handles billing and loan repayment.

When your payments are due and how much you must pay depend on the terms of your repayment plan. With private student loans, your lender will determine your repayment plan – and you may not have many options to change or lower your monthly amount due. Federal student loans, on the other hand, allow students to choose from a variety of repayment plans, Federal Student Aid reported. Options include fixed or graduated payments, income-based repayment plans and extended repayment options that give you as long as 25 years to pay back your debt.

When you’re first learning about student loans, the whole idea of taking on debt to pay for your college education can seem overwhelming. Understanding what to expect from your student loan experience, how you attain the loans you need to afford a college education and what the loan repayment process will be like can help you put things in perspective. Informed borrowers can make smart decisions about when to apply for aid, where to turn for funding and how much debt they should accept.

Attaining a college education is an investment in yourself and your future career – and just like any investment, there’s both a cost and a potential benefit involved. Student loans are a perfectly practical – and often, necessary – source of funding that can help put you on the path to a better career.

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