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how do student loans work

How Do Student Loans Work?

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A college degree paves the way for employment, increased income, and financial stability. It also leaves nearly 70% of graduates with student loan debt.

Loans are the only way many students can afford a college education. Americans owe a collective $1.6 trillion in student loan debt, with the average debt being about $30,000 .

Applying for different types of student loans, or even knowing where to start, can be an arduous process. We’ve broken down the types of loans, programs, and repayment options to help you get the most out of your money and your education.

Types of Federal Student Loans

The first step for every student, whether or not they think they will need a loan, is to fill out the Free Application for Federal Student Aid, more commonly known as the FAFSA from the US Department of Education. This will allow you to apply for federal aid, including grants, loan programs, and work-study programs to cover the cost of attendance.

Once the application process is complete, you and your potential schools will be sent a Student Aid Report, or a SAR, that includes your Expected Family Contribution, or EFC, which will determine your eligibility for a federal Pell grant.

Colleges will also use the EFC to determine what other types of aid you may be eligible to receive, including additional federal aid, school scholarships, work-study, or other types of student financial aid. Make sure to max out any gift aid options for financial aid before looking into your loan options for the school year.

Both undergrad and graduate students who have never taken out a federal loan will need to complete entrance counseling, which is required by the federal government to ensure you understand your responsibilities and repayment term obligations.

Your school may have its own entrance counseling. Check with your school’s financial aid office to make sure the entrance counseling you complete satisfies the government’s requirements.

Experts say that all students should fill out the FAFSA, whether or not they think they need or qualify for federal financial assistance for your higher education. Not only does it give you a safety net if your financial need or college costs change at any point during your college career, but it also puts you in line for school-subsidized financial gifts for all income brackets. Filling out the FAFSA can even boost your enrollment chances because it shows schools you listed them to receive information about you and are committed to your education.

Here are the different types of federal loans and which student loan borrower they apply to:

Loan Type Borrower Fixed Interest Rate
Direct Subsidized Loans and Direct Unsubsidized Loans Undergraduate students 4.53%
Direct Unsubsidized Loans Graduate or professional students 6.08%
Direct PLUS Loans Parents and graduate or professional students 7.08%


These are the limits on federal loans, depending on the borrower and loan type.

Year Dependent Students  Independent Students (and parents of dependent undergrad unable to obtain PLUS Loans)
First-Year Undergraduate Annual Loan Limit $5,500 – No more than $3,500 of this amount may be in subsidized loans. $9,500 – No more than $3,500 of this amount may be in subsidized loans.
Second-Year Undergraduate Annual Loan Limit $6,500 – No more than $4,500 of this amount may be in subsidized loans. $10,500 – No more than $4,500 of this amount may be in subsidized loans.
Third Year and Beyond  Undergraduate Annual Loan Limit $7,500 – No more than $5,500 of this amount may be in subsidized loans. $12,500 – No more than $5,500 of this amount may be in subsidized loans.
Graduate or Professional Student Annual Loan Limit Not Applicable $20,500 (unsubsidized only)
Subsidized and Unsubsidized Aggregate Loan Limit $31,000 – No more than $23,000 of this amount may be in subsidized loans.

$57,500 for undergraduates – No more than $23,000 of this amount may be in subsidized loans.

$138,500 for graduate or professional students – No more than $65,500 of this amount may be in subsidized loans. 

*The graduate aggregate limit includes all federal loans received for undergraduate study.


Federal student loan repayment options

After graduation or enrolling part-time or less (as defined by your school), borrowers of federal student loans will enter repayment. At this time you can see who will be servicing your repayment for the life of the loan and select from standard repayment plan options (like income-contingent repayment) for federal borrowers by contacting your servicer.

Grads may also choose to roll all of their loans into one easy payment with a direct consolidation loan. Alternatively, if a graduate is not utilizing a federal repayment benefit, they may choose to refinance to lower their student loan interest rate.

Private Student Loans

When federal assistance isn’t enough to pay for college — whether you weren’t approved for what you need or you need more than the federal limit on how much you can borrow — private education loans can help you cover the gaps in funding.

Students apply with the lenders. While many lenders will look at your credit score to determine the loan amount and terms, you may be able to get a quote without a credit check. Bad credit score or no credit history? You may have to take on a higher interest rate, or you can ask a parent or other financially responsible adult with a good credit score to be a cosigner on your loan. Having a cosigner may also help you get a lower interest rate than you could have when applying on your own. 

Just make sure you will be able to stick to your repayment plan so your cosigner doesn’t get stuck with the tab and the interest.  

Private lenders work directly with your school and, just like federal loans, student loan payments are made to the financial aid office.

When Student Loan Repayment Begins

Thinking about loan payments should begin before you sign your loan agreement. Ask the lender when repayment begins so you can be prepared to tackle the loan balance.

Repayment for federal student loans typically begins after graduation (or after you drop below half-time enrollment), while private lenders may require monthly payments while you are still in school. Federal loan holders typically get a grace period of six months between the time they graduate and the date repayment begins.

Interest typically starts accruing on the loan before you begin repayment, including during the grace period, but making payments while you are still in school can lessen the impact and make repayment seem less daunting. If you have a subsidized federal loan, the government will cover your interest payments until the end of your grace period. 

Federal Loan Servicers

Your federal loan will be transferred to a company called a loan servicer, which handles the billing, sending the loan disbursements to your school and answering questions about repayment or loan terms. You can also reach out to your loan servicers for information on student loan forgiveness.

Graduates who are in repayment can find out who their loan services are — each loan might have multiple servicers — by logging into My Federal Student Aid

Private Loans

Private lenders and financial institutions may also use loan servicers, while others — including Earnest — take care of all your loan information in-house. In that case, you can reach out directly to your lender to get information on your repayment plan or get help managing your loan debt.

Deferment and Forbearance

If you find yourself unable to make your monthly payments, you will need to check in with your loan servicers about whether you qualify for deferment or forbearance to temporarily pause your payments.

Deferment can pause your loans for up to three years during loan repayment and generally a better financial choice if your federal loans are subsidized because you may not accrue additional interest payments during your deferment period. Deferment qualifications are based on unemployment or significant financial hardship, such as homelessness, military deployment, or major medical treatments.

A forbearance may be approved for those who do not qualify for deferment. During forbearance, loans are either paused or reduced for up to 12 months. The glaring financial difference between the two options is that interest will continue to accrue on the original loan amount in forbearance. 

If at all possible, an income-based repayment plan is likely a better option than deferment or forbearance because you can continue making payments without letting interest pile up.

Conquer your student debt. Refinance now.

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Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.