How Student Loans Work

Loan Guides      Student Loans      How Student Loans Work

Before taking out a student loan it is important to understand how student loans work. These products allow students to borrow money to pay for their college expenses. Money can be applied to tuition, room and board, books, and other living expenses while going to college or graduate school. A large portion of this market is sponsored by the United States government. This allows for these to have generally low interest rates and flexible terms. They are provided based on the understanding that students will need time after completing school to pay them back.


How Student Loans Work

Let's understand how student loans work. They can be obtained from both private and federal lenders. Depending on the borrower you choose, the process might be slightly different, however, in general, federal and private obligations operate similarly. When you are granted one, it is initially disbursed to your school. After your tuition and fees are covered, the remaining money is given to you to pay for additional costs such as housing or books. These surplus funds can also be returned to your lender if they are not needed.

If borrowing from the government, you will need to reapply for financial aid every year. However, private lenders may develop their own terms which could require you to reapply every semester. Some lenders may also require minimum grades as well as enrolling in a set number of credit hours.

Student Loan Interest Rates

Interest rates, or annual percentage rates (APR), need to be taken into account to determine the full cost over time. Interest rates are dependant on who you borrow the money from.


For federal, interest rates are set by the United States Congress. Federal products come at fixed interest rates, meaning they will not fluctuate over time. On the other hand, private lenders will often offer you variable interest rates. Variable interest rates may seem appealing, as they begin with very low interest rates, however as interest rates increase towards the end of your term, they may end up costing more overall. Private lenders will examine your credit score to determine the interest rate on your balance.

Lastly, in many cases, interest will be deferred until after you graduate. This means that you will begin accruing interest once you have graduated and are required to start paying back your oustanding balance. This may not be the case with all private lenders. Some charge interest starting at the time of disbursement of funds. You should carefully review the terms when shopping around with private lenders.

Types of Student Loans

Before taking out debt, you need to understand how student loans work and what your options are:


The United States Government offers several student programs. The William D. Ford Federal Direct Program currently offers three different choices: Direct Subsidized, Direct Unsubsidized, and Direct PLUS. Direct Consolidation allow borrowers to utilize several types of federal options.

The basic eligibility requirements for all three types of federal options are the same. Some of these include being enrolled at least half-time or being accepted into a qualifying degree program. Individuals applying for one will have to go through the Free Application for Federal Student Aid (FAFSA).

While the different types of federal options share several similarities, they are not the same. These may have different interest rates, annual limits, disbursement fees, and other factors. Your terms may also be affected by your status as a student, such as being an undergrad, graduate student, parent of a student, etc.


Direct Subsidized are only available under certain circumstances. First, you have to be an undergraduate. Also, your school has to determine your eligibility based on tuition costs and the expected contribution from your family. Your borrowing limit may increase as you progress through school. However, if your financial needs decrease, then so could your borrowing limit. With Direct Subsidized, the government will pay the interest that accrues on your balanec while you are enrolled at least half-time.

Due to low interest rates, low disbursement fees, and subsidization, Direct Subsidized are typically the best option for students in need of financial assistance. However, depending on your financial circumstances, you may not qualify for enough money to pay for all of your expenses.

Direct Unsubsidized

Unsubsidized are available to both undergraduate and graduate students. They do not require you to demonstrate financial need. Unsubsidized also generally have larger borrowing limits than subsidized. Your limit will be affected by factors such as your dependency status and field of study. Other factors that affect the amount you can borrow include your tuition costs, how much financial aid you have received from other sources, and your family's ability to contribute to your education.

For undergraduate students, these unsubsidized have the same interest rates and fees as subsidized. However, since there is no subsidy, you will likely end up with a lot more debt. For graduate students, you may be better off pursuing a private student option if you have a decent credit score. Direct Unsubsidized are not always the best option, but they can be a great alternative for students who do not qualify for a Direct Subsidized.

Parent PLUS

Parent PLUS are one of two types of Direct PLUS. These can be borrowed by parents to help pay for their dependents’ education. In addition to the basic requirements set for students, parents must also undergo a background check when applying for a Parent PLUS. However, even if they do not pass the credit check, parents may still qualify through the use of a cosigner.

For Parent PLUS, parents must request a deferment. Otherwise, payments start immediately after the money is disbursed. Deferment will generally work the same as for student borrowers. This means payments are suspended as long as the student is enrolled at least half-time. However, interest will still accrue during this period.

Keep in mind that Direct PLUS have the highest interest rates and disbursement fees out of all the different federal student programs. However, if it is between this and a private option, you may find a Direct PLUS to be the better option. Additionally, Parent PLUS cannot be transferred to the student, but can potentially be refinanced through a private lender.


Grad PLUS can be taken out by graduate and professional students to help cover educational expenses. These are subject to the same fees, limits, and credit checks as Parent PLUS. Grad PLUS are automatically deferred until six months after you stop being enrolled half-time at your school. Additionally, these are eligible for all of the income-driven repayment plans.

Grad PLUS do not have pre-set borrowing limits, meaning you can borrow enough to cover the cost of attendance at your school, however, higher interest rates on Grad PLUS might make a private or a Direct Unsubsidized a better option for you.


Private student obligations are simply those that you borrow from a non-government provider. These must still be used for educational expenses and are still subject to some federal laws. As an example, private lenders cannot charge any fees for paying off your balance early.

- Advantages:

  • Interest Rate Discounts: Signing up for autopay grants you a 0.25% interest rate discount for federal and private student options.
  • No Funding Fees: Private lenders do not typically charge origination or disbursement fees.
  • Large Borrowing Limits: Many federal programs have pre-set borrowing limits. On the other hand, private lenders will often let you borrow up to your school’s cost of attendance.
  • Potentially Low Interest Rates: Students with good credit may be able to get lower interest rates from a private lender.
  • Variable-Rates: Variable-rate programs generally start with lower interest rates than fixed-rate. Be careful, though, as interest rates are generally trending up right now.

- Disadvantages:

  • No Federal Benefits or Programs: Private student options do not offer benefits such as federal repayment plans or subsidies.
  • Few Hardship Options: Private lenders often do not offer deferment options or other plans to help students who have trouble making payments.
  • Credit Requirements: Private lenders perform thorough credit checks to determine the option that they are willing to offer you. Many federal programs do not do this.
  • Discharge Policies: Federal programs allow borrowers who become disabled or die to discharge their balanes. Private lenders do not always offer this, which would leave your estate or cosigner with your remaining balance. In addition, most student debts cannot be discharged through bankruptcy. You can only do so by showing significant financial hardship for yourself and your dependents. More information is available from the SBLA.
  • Defaults: Private student options generally default quicker than federal student obligations. When you default on your balance, you immediately owe the entire amount. Federal programs also typically provide ways to get out of default whereas private lenders do not.
  • Repayment Assistance Programs: Many \repayment assistance programs will not assist you in repaying a private debts.

Where to Get Private Money

Private options can be obtained from a variety of sources, including banks, credit unions, states, schools, and online lenders. You can find reputable lenders through recommendations from friends or by consulting with your school.

When searching for a private lender, be sure to compare multiple offers to determine the lender with the best terms for you. You should compare interest rates, fees, restrictions, and discounts to be sure that you get the best offer available.

Should You Go The Private Route?

For most students, federal programs are the best option available. However, in some circumstances, a private option might be preferable or necessary. For example, if your federal options are not enough to cover your full cost of attendance, you may need to take out a private note to cover the rest of your expenses. Or, if you or your parents have an exceptional credit history, private options may offer more favorable interest rates than federal programs. Before taking out a private debt, you should consider the benefits and drawbacks of doing so compared to borrowing a federal program.

How Much Student Loan Can You Afford to Take Out?

How much you can afford to borrow is highly dependent on the interest rate. It is key understanding how student loans work. While private interest rates widely vary, federal are set by the U.S. Congress every year. Once your money has been disbursed, your interest rate cannot be changed unless you refinance.

For July 1, 2018, to June 30, 2019, the federal interest rates are as follows:

  • Direct PLUS: 7.60%
  • Direct Subsidized: 5.05%
  • Direct Unsubsidized for Undergraduates: 5.05%
  • Direct Unsubsidized for Graduates: 6.60%

Most options defer repayment until after you have completed college, plus a grace period. This gives you time to establish a job and begin your career. Know that you will need to begin repayment of your balances if you fall below the minimum credit hours or leave school. However, there are some options available for forgiveness or cancellation. These include becoming a teacher or completing public service. You can find a full list of these options available at the government student aid website here.

How to Get a Student Loan

The process for applying depends on whether it is a federal or private.

Apply for a Federal Student Loan

To obtain a federal, you must submit a Free Application for Federal Student Aid (FAFSA) every year. You should fill out your FAFSA as early as possible, as some states and institutions grant financial aid on a first-come, first-served basis. Filling out your FAFSA may also be a requirement before applying for other forms of financial aid.

Go to and create your FSA ID to begin your application. In some cases, your parent or other cosigner might also need to create an FSA ID. After you have created your account, go to to start your application. You will need:

  • Financial forms such as W-2s and income tax returns
  • Your social security number
  • Bank statements
  • Your parents’ social security number and income-related forms, if you are a dependent

Typically, it takes less than an hour to finish filling out your FAFSA. If you are a first-year student, you can send your application to the schools that you are considering attending. Existing students will send their application to their current school.

You will receive a Student Aid Report (SAR) after submitting your FAFSA. This report details your FAFSA information and your family’s expected contribution. Ensure this information is correct as this is what schools and states use to determine your financial aid eligibility.

Next, your school, or schools, will send you offers for financial aid packages. This could include student loans, grants, scholarships, work-study funds, or other types of financial aid. You should pick the package that best suits your needs. Remember that you do not have to accept the full amount that is offered.

Apply for a Private Student Loan

Private lenders will have their own unique application processes. You will not need to fill out your FAFSA to take out a private debt. However, you will likely need to have much of the same information available to fill out your private application. Additionally, you will need to have the information of your cosigner, if you are using one.

If your application is approved, you may be given multiple offers to choose from. In this case, be sure to consider the long-term cost of each offer. Do not immediately choose the one with the lowest initial interest rate.

Best Student Loans Lenders

As stated throughout this article, federal programs are, more often than not, the best option available. However, in some cases, you may be able to obtain a notewith more favorable terms from a private lender. Unfortunately, there is no single best lender out there. It all depends on your financial circumstances, credit history, and educational expenses.

You can check out your local bank or do some online searches for private lenders. However, remember that these companies might not necessarily be your best option. Always make sure to compare your personalized offers to find the best deal available.

Tips to Find the Right One for You

Make Sure to Get Pre-Approved

This tip applies mostly to students looking for a private lender. Remember, private debts do not have set interest rates like federal programs. As such, it is important that you are able to get all the information possible in order to compare different lenders.

Pre-approval generally requires you to submit fairly basic identifying and financial information. In some cases, you may also be subject to a soft credit check. Using this information, private lenders may be able to provide you with more information on what interest rates, fees, and other terms you might be eligible for.

Compare Offers

With student debts, it is important that you carefully compare offers between potential private lenders as well as between your federal programs.

Interest rates, in particular, can drastically increase the long-term cost. As a result, it is important that you compare your variable-rate offers with the fixed-rate provided by federal programs.

Consider All of Your Expenses

Educational expenses go far beyond tuition and room and board. Student, federal or private, can be used for a wide variety of expenses that you might not think of. For example, school books, a laptop, and gear for your dorm can all be paid for with student loan money if you do not have any other funds to cover those costs. Additionally, they may be used to pay for transportation to and from school.

Factoring in all of your required expenses can help you be sure that you take out as much as you need without going into unnecessary debt.

Student Loans FAQs

- What Can The Money Be Used For?

They can be used to cover any expenses related to your education. These include tuition, room and board, and books. They can also include expenses related to your ability to attend school, like transportation costs, food, and other living expenses.

- Do I Need to Demonstrate Financial Need for a Federal Options?

The short answer is no. Direct Subsidized are often only available to students who demonstrate financial need. Direct Unsubsidized and Direct PLUS can be obtained by students with no demonstrable financial need.

- When Will I Get My Money?

Funds are disbursed to your school to cover tuition and fees. After these costs have been covered, your school will give you the remaining amount of financial aid.

-What if I Drop Out of School?

Most deferment programs require you to be enrolled at least half-time. Dropping out of school may result in you having to immediately begin paying back your balance.