How do Student Loans Work?

Education is a tool that can create social mobility for some. For this reason, many are willing to take out financing to fund their education when they don’t have cash to do so. A common way to finance education is through student loans. A student loan is money borrowed from a private institution or the federal government to fund education expenses. These types of loans are a major financial commitment, so understanding how they work is critical.

How Student Loans Work

Student loans are often issued by banks or the U.S. Department of Education in the form of federal loans. They provide prospective students money that has to be repaid with interest over time. There are two types of loans – private and federal. Here is a brief explanation of how each works.

Private student loans
These types of loans come from banks, credit unions or online lenders. To get approved for a private student loan, one usually has to jump through more hoops than with a federal loan. Some prerequisites might include needing a strong credit history which comprises a score 670 or above, or a co-signer. Steady income is usually also a requirement from lenders to increase the likelihood of loan repayment. Some private lenders don’t require a strong credit history and can work with bad credit, but that often means higher interest rates.

Speaking of which, interest rates on private loans are sometimes higher than with federal loans. However, if the borrower has a relatively high credit score, they could obtain a lower interest rate.

Private loans offer two options as it pertains to interest rates: fixed and variable. Fixed interest rates means the rate stays the same throughout the duration of the loan. Variable is the opposite, since the interest rate changes periodically.

An upside to private student loans is individuals can sometimes borrow more than they could with federal loans. That said the borrow limit varies between lenders.

Federal student loans
Federal student loans are funded by the federal government, with interest, and usually the first option for borrowers.

To apply, prospective students fill out the Free Application for Federal Student Aid also known as the FAFSA. The information provided on the form helps states and colleges determine the applicants eligibility.

Benefits of federal student loans include fixed interest rates and income-driven repayment plans, which allow borrowers to pay back based on their income.

There are four types of federal student loans available, which include:

• Direct Subsidized Loans: For students who can demonstrate financial need
• Direct Unsubsidized Loans: these loans are extended to anyone in need of financial aid but aren’t based on financial need
• Direct PLUS Loans: These loans are targeted at students who need help with education expenses not covered by financial aid. Credit checks are required and there are minimum requirements.
• Direct Consolidation Loans: All eligible student loans can be consolidated or bundled into a single loan with this option.

Repayments Of Student Loans

As with any loan, student loans typically have to be repaid with interest. The main difference between student loan repayments and car loans, for instance, is that repayment can sometimes be deferred, especially with federal loans. In other words, loan repayments may not commence until the borrower has finished school or stops attending. That said, some private loans require repayment while the borrower is studying.

The interest rate for student loans hinges on the lender and the terms they set. As mentioned earlier, some loans may have fixed interest rates, while others may be variable.

In some cases, federal loans may be forgiven, especially for those who work in certain professions, such as teachers or public service workers.

Weighing The Risks And Rewards

As with any loan, it’s important to weigh the risks before committing to student loans. That means evaluating the true cost over the lifetime of the loan. There are student loan calculators that can help with this math. Consider using the Department of Education’s loan simulator to get an idea of what loan repayment schedules might look like.

It’s also essential to think about how much income will go towards repayment, and how that may impact your future finances. In addition, to ensure there’s a return on investment on the loan, think about how much you could potentially make in the tentative career the loan helps you establish. Also, work towards getting the best possible rates and lowest fees on the loan. Finally, making extra payments could lead to paying less in interest throughout the lifetime of the loan, but borrowers of government loans should consider the loan forgiveness policies that may be available to them. It may not make sense to pay extra if your loan will be forgiven due to public service loan forgiveness (for employees of public entities), so be sure to consider your options carefully. Consider consulting a financial planner to help in the decision making process.