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Student loans: How they work

Student Loans
Erik Martin
UpdatedMay 3, 2022
Key Takeaways:
  • Student loans are available through the government and from private lenders.
  • Student loans can help you afford higher education to increase your earnings.
  • Student loans can get you into trouble if you don’t plan for repayment

The costs associated with attending a college or university can be increasingly expensive. That’s why many students and their families seek help in the form of financial aid provided by the school and other organizations. But these funds may only take you so far. If you have a financial shortfall, you may want to borrow money in the form of student loans.

Learn more about how student loans work, the differences between federal student loans and private student loans, how to apply for student loans, how to pay off student loans, student loan refinance options, and student loan forgiveness.

How student loans work

A student loan is a type of financial aid provided to students to assist in funding the cost of higher education. Student loans have to be repaid with interest. Student loans can either be federal loans, in which the government lends the money, or private student loans, in which a bank, lender, or other organization provides the funds.

“Student loans are granted to college students to cover their tuition, room and board, and other education-related expenses,” says Melanie Hanson, editor in chief of EDI Refinance. “They are generally designed to be paid back after graduation, and there are many regulations and federal subsidies in place to support borrowers throughout the process.”

Federal student loans

The US Department of Education’s federal student loan program is also called the William D. Ford Federal Direct Loan Program. There are four types of federal direct loans available: direct subsidized loans; direct unsubsidized loans; direct PLUS loans; and direct consolidation loans.

“Federal student loans usually have lower interest rates and more favorable repayment terms than private loans,” says Scott Winstead, founder/higher education expert at “When you take out a federal loan, the US Department of Education is your lender.”

The most common type of federal student loan is the Stafford loan, which can either be subsidized or unsubsidized.

“Subsidized Stafford loans are need-based, meaning that the federal government pays the interest while the borrower is in school and during grace and deferment periods,” Winstead adds. “Unsubsidized Stafford loans are not need-based, so the borrower is responsible for all of the interest that accrues on the loan.”

The other most common type of federal student loan is the Perkins loan, which is only available to students with exceptional financial needs. As with Stafford loans, the federal government pays the interest on Perkins loans while you remain in school and during grace and deferment periods.

Both Perkins and Stafford loans have a relatively low fixed interest rate that Congress sets.

Direct subsidized loans

Direct subsidized loans are the best types of loans borrowers can hope to get, as they come with the most support from the government, per Hanson.

“They tend to come with lower interest rates and more repayment options. Most student loan applicants can expect to get some subsidized loans, but it’s rare to get enough of them to cover your entire college education,” Hanson notes.

Only undergraduate students who demonstrate financial need qualify for direct subsidized loans.

With direct subsidized loans, the government waives any interest that accrues over particular periods of deferment, such as when a student is still in school.

“As a result, subsidized loans are generally less expensive to repay than unsubsidized loans,” says Jessica Ferastoaru, a student loan specialist with Take Charge America, a nonprofit financial counseling agency.

Direct unsubsidized loans

Both undergraduate and graduate students can qualify for unsubsidized loans without demonstrating a financial need to qualify.

“Since these loans are unsubsidized, interest will accrue while the student is in school and during periods of deferment. As a result, unsubsidized loans are typically more costly to repay compared to subsidized loans,” Ferastoaru explains.

Direct PLUS loans

Graduate students or parents of undergraduate students may be eligible for Direct PLUS loans, regardless of their financial need. To qualify, students or parents have to complete a credit check to prove that they don’t possess an adverse credit history.

“PLUS loans charge a higher interest rate than Stafford or Perkins loans,” cautions Winstead.

Direct consolidation loans

Direct consolidation loans permit you to roll all of your eligible federal student loans into a single loan handled by a single loan servicer.

“The resulting consolidation loan will generally allow borrowers to make a lower payment over a longer loan term,” says Ferastoaru. “However, the interest rate will not be reduced. The interest rate on a direct consolidation loan will be the weighted average of the interest rates on the consolidated loans.”

Private student loans

Uncle Sam isn’t the only source for student loans. If you don’t qualify for federal loans or need extra financial assistance, you can explore private student loans, typically offered by banks, credit unions, schools, and other private lenders. Often, a credit check is required to qualify for a private student loan.

“Private student loans usually have higher interest rates than federal student loans, and the terms and conditions may vary depending on the lender,” Winstead continues. “Some private lenders offer loans that do not require a co-signer. However, most private lenders require a co-signer, typically a parent or other family member.”

It’s best to exhaust all federal student loan options before committing to private student loans, as interest rates for the former are commonly lower, and you may be eligible for income-based repayment plans with federal loans.

Be aware that private student loans are not federally guaranteed. If you default on the loan, the lender is not required to repay the loan.

How to apply for student loans

The first step involved in applying for student loans is to complete the Free Application for Federal Student Aid (FAFSA) form, found at You can also apply for private student loans directly with a lender, bank, school, or other private organization offering them.

How much can a student borrow?

A federal student loan borrower can only borrow up to a certain amount of subsidized or unsubsidized loans every year.

“Currently, the maximum annual amount an undergraduate student can borrow ranges from $5,500 to $12,500, depending on what year of school the borrower is in,” says Ferastoaru. “For graduate students, the annual limit is currently $20,500.”

Hanson points out that, over all your years in college, currently you are limited to $57,500 in student loans as an undergraduate, no more than $23,000 of which can be subsidized. Graduate students can borrow up to $138,500, with a maximum of $65,500 being subsidized.

Good candidates for student loans

Any student who cannot pay for the cost of college upfront can be a good prospect for borrowing money via student loans.

“While student loans are a necessary part of life for most people who want to attend college today, the ideal candidate is someone who is doing everything they can to minimize their cost of attendance and has a clear career plan that will earn them enough income to repay these loans in a timely fashion,” says Hanson.

How to pay off student loans

Borrowers can make payments on their student loans at any time.

“That means while they are in school, during the grace period, or when loans enter repayment at the end of the grace period,” Ferastoaru says. “Most federal student loans will enter a grace period for six months after the student graduates or leaves school.”

In other words, student loan repayments typically are required to begin six months after you graduate or otherwise leave school. Most loans are repaid over 10 years. The loans will be placed with a servicer – a company responsible for managing the billing and repayment programs for the student loan.

You can make student loan payments by mail, over the phone, or on your servicer’s website. At the end of your grace period, minimum payments will be set based on the standard 10-year repayment plan unless you request a change to a different repayment plan or decide to consolidate your loans.

“If your standard set payment amount is not affordable, you can choose a different repayment plan, such as an income-driven repayment plan,” adds Ferastoaru.

Pursuing a student loan refinance

If you are struggling to repay your student loans, you might want to consider refinancing them.

“When you refinance, you take out a new loan, hopefully with a lower interest rate, and use it to pay off your existing loans,” Winstead explains. “This may help you save money on interest and lower your monthly payments. Or, you can opt to extend the term of your loan, which will lower your monthly payments even further. Just remember that extending the term of your loan will also increase the total amount of interest you will pay over the life of the loan.”

You will also need to meet specific credit and income requirements to qualify for a refinance loan, and you may need a co-signer if you can’t qualify on your own, according to Ferastoaru.

Pursuing student loan forgiveness

Student loan forgiveness is a process in which you can, in some cases, have some of your student debt discharged without having to repay it.

“Forgiveness programs tend to be few and far between and come with many conditions. Working in the public service sector in a low-income area is a frequent prerequisite,” Hanson points out.

Several federal student loan forgiveness programs exist (private student loans can’t be forgiven under these programs), including Public Service Loan Forgiveness (PSLF), Teacher Loan Forgiveness, and Income-Driven Repayment (IDR) Plan Forgiveness.

“Borrowers may also qualify for a loan discharge under certain scenarios, such as if they were defrauded by their college or university or if they become totally and permanently disabled,” Ferastoaru says.

What to consider before applying for student loans

Eric Jeanette, the owner of Dream Home Financing and FHA Lenders, recommends thoroughly reading and fully understanding all the fine print and details of any student loan you intend to sign.

“This includes the interest rate, loan term, and what will happen if you cannot make payments,” he says. “We often see individuals who have extremely high student loan debt because the balance accrues interest at a faster rate than they can pay down the loan.”

Also, carefully consider the amount of debt or overall cost of education for the field you are studying.

“Your student loan debt should not exceed what you could realistically earn in your field of study. Ask yourself whether the job you will eventually get will compensate you enough to actually pay down the loan within a reasonable amount of time,” adds Jeanette.

Frequently Asked Questions

What are good alternatives to student loans?


Alternatives to student loans, such as grants, scholarships, work-study programs, and exploring options like living at home to save on the cost of room and board, should all be considered before taking out student loans, according to Jessica Ferastoaru with Take Charge America.

Is a student loan refinance worth it?


It may be worthwhile to pursue a student loan refinance via a private lender if you seek to keep your monthly payments under control and have increasing debt. But this option isn’t recommended if the new refinance loan charges a higher interest rate and has unfavorable repayment options.

How do you earn student loan forgiveness?


Borrowers who work for the government or a nonprofit organization, become a teacher at a qualifying school, have made payments for 20 or 25 years on an income-driven repayment plan, were defrauded by their university or college, or who have become totally and currently disabled are among those who may qualify for forgiveness of their student loans.