How do student loans work? Guide for new borrowers

If you’re heading to college, you might be considering student loans to help cover costs—and you wouldn’t be alone. Students and parents borrowed a total of $98.2 billion in federal and private student loans for the 2022-23 school year as reported by the College Board. These loans can be essential for covering tuition, room and board, textbooks, and other educational expenses when grants and scholarships aren’t enough.  

But before you sign any loan agreement, it’s important to understand the different types of student loans and how they work. Here’s what you need to know before you borrow. 

How do federal student loans work? 

Federal student loans are offered by the U.S. Department of Education. Different loan programs are available to undergraduates, graduate students, and parents of undergraduates. All federal student loans can all be accessed through the Free Application for Federal Student Aid (FAFSA):

• Subsidized Direct Loans: Subsidzed loans are need-based loans that are accessible to undergraduate students. The government pays the interest on these loans while you’re in school and during a six-month grace period after graduating or dropping below half-time enrollment. 
• Unsubsidized Direct Loans: Unsubsdized loans are available to undergraduate, graduate, and professional students. These loans aren’t based on financial need or credit history, making them one of the easiest student loans to obtain.
• Direct PLUS Loans: Direct PLUS Loans can cover up the full cost of attendance at your school unlike subsidized and unsubsidized loans. Grad PLUS loans or only available to graduates and professional students, while parent PLUS loans are reserved for parents of dependent undergraduates.

To take out federal loans, you must be a U.S. citizen or eligible noncitizen, be enrolled in a qualifying school and degree or certificate-granting program, and meet other criteria. 

Interest rates and fees

Federal student loan interest rates are fixed, meaning they remain the same for the duration of the loan. Rates are set annually by Congress and they’re based on the 10-year Treasury note yield. Here’s a look at current interest rates and fees for the 2024-25 school year: 

Application process

You can apply for all federal student loan types with one convenient application. The Free Application for Federal Student Aid (FAFSA) is the official form that’s used to determine your federal aid eligibility. There’s no cost to submit the FAFSA and through it, you can access grants, work-study opportunities, and federal student loans. It can be completed and submitted conveniently online:

1. Gather your personal information. This includes your Social Security number, driver’s license, federal tax returns, documents for other income sources.
2. Create a Federal Student Aid ID. This is the login you’ll use when working on, submitting, and revisiting your FAFSA online. It also acts as your electronic signature on federal student aid documents. 

• Complete the FAFSA. Fill out your FAFSA for the academic year you’d like to receive financial aid. It takes approximately one hour to complete the form.

Your school will review your FAFSA and identify the types of federal aid and amounts you qualify for, if any. Be sure to fill out the FAFSA and submit it as soon as annual applications open on October 1st. The deadline to submit the 2024-2025 FAFSA is on June 30, 2025.

Repayment 

Federal Direct Loans are broken down into fixed payment repayment plans and income-driven repayment (IDR) plans. Loan terms can range from 10 years to 30 years, depending on your repayment plan and loan type:

• Standard Repayment Plan. This plan divides your principal balance into 120 equal monthly payments (10 years), plus interest. This is the default plan for federal student loans. 
• Graduated Repayment Plan. Payments start low, and gradually increase every two years or so over a 10-year term. 
• Extended Repayment Plan. Monthly payments are fixed or graduated, but the loan is paid over 25 years.
• Income-driven repayment plans: Income-driven repayment (IDR) plans determine your monthly payment based on your income and family size. There are four IDR plan types including SAVE, PAYE, IBR, and ICR. Loan terms range from 10 to 25 years depending on the plan.

How do private student loans work? 

Private student loans are provided by non-federal lenders, like banks, credit unions, and online lenders. Your state or school might also have its own private loan program. Student loans from private lenders might have fixed or variable rates, and loan terms and repayment options vary between lenders.

To qualify for a private student loan, lenders usually require a credit score in the mid-to-high 600s. They also look at your income, employment status, and sometimes other financial factors to evaluate your ability to repay the debt. That’s why a good credit history can be crucial for securing a private student loan. 

Since most dependent undergraduates are unable to qualify on their own, they often need to bring on a cosigner, such as a parent or family member, who can meet these requirements. A cosigner is someone who agrees to take on responsibility for the loan alongside the primary borrower. This means that if you’re unable to make payments, your cosigner will be legally responsible to pay back the loan.

Check Out: Best Student Loans For Bad Credit 

Interest rates and fees

Unlike federal student loans, private student loans have interest rates that can be either fixed or variable. Variable rates may start lower than fixed rates but they can fluctuate over time with market conditions. Most private lenders don’t charge loan origination or application fees. 

Several factors can influence the interest rate you get on a private student loan. For example, your credit score, which reflects your history of managing debt. Higher scores often qualify for lower rates. The length of your loan term can also play a role. Shorter terms generally have lower interest rates because the risk to the lender is reduced.

Application process

Private loans don’t have a universal application. Each lender sets its own eligibility criteria — including credit and income requirements — and has different rates, terms, repayment plans and hardship programs. Each private loan is different so compare a handful of student loan offers, before applying. 

The application process for private student loans includes a thorough credit check that will temporarily impact your credit score. It’s a necessary step that’s part of the lender’s assessment to determine the risk of lending to you. 

Many private lenders let you pre-qualify for a loan to see your estimated rates before submitting a formal application. Since undergraduate students might not have established or positive credit histories, some lenders require a co-signer when applying for a private student loan.

Repayment 

Private student loans don’t adhere to federal repayment options. Private lenders set their own repayment options, with terms typically ranging from 5 to 20 years. Opting for a shorter repayment term results in higher monthly payments but allows you to clear your debt sooner. A longer repayment term, on the other hand, lowers your monthly payments but increases the total interest paid over the life of the loan. 

How does interest work on student loans?

How interest is applied to your student loan balance depends on the method used by your lender. Most student loans, including federal student loans, accrue interest daily. 

Interest on student loans can also be capitalized, which is a key concept to understand since it affects how much you’ll ultimately pay back. Capitalization happens when the interest that accumulates on your loans is added to your principal loan balance, leading to a higher loan amount and more interest charges over time. 

Capitalization typically occurs if you don’t pay interest on your loans during periods of deferment such as while you’re in school and during your six-month grace period. The only exception is with Federal Direct Subsidized Loans. Since the government pays interest on these loans while loan payments are paused, there’s no interest that can be capitalized. 

Managing student loans post-graduation

See if you qualify for loan forgiveness

Your unpaid federal student loan balance might be forgivable if you meet certain program criteria, like working for a nonprofit or government entity. Explore forgiveness programs like Public Service Loan Forgiveness and Teacher Loan Forgiveness to see if you qualify.

Request an IDR plan

If you’re experiencing hardship with repaying your federal student debt, speak to your loan servicer about getting on an income-driven repayment plan. IDR plans re-calculate your payments based on your income and family size, and some borrowers qualify for monthly payments as low as $0. These plans also forgive your remaining loan balance at the end of your repayment period. 

Refinance student loans

If market rates drop, it might be in your interest to see whether student loan refinancing is a good fit. Refinancing your student loans might help you secure a lower interest rate than you currently have. Conversely, you can choose to refinance for a longer term to reduce your monthly payments if they’re unmanageable now. This option, however, results in paying more interest over time.

FAQ 

How do student loans work? 

A student loan is a type of financial aid option. You can find student loans through federal and state government programs, your school, or a financial institution like a bank, credit union or online lender. The money that you borrow must be repaid with interest. You’ll repay the loan over time, sometimes over 10 years or longer. 

How and when are student loans disbursed?

Federal student loans are typically disbursed directly to your college or university’s financial aid office. Federal loan funds are typically disbursed to your school a few days after the start of the academic year. For private student loans, the lender might disburse funds directly to your school or to you; additionally, disbursement dates can vary. 

How much can I borrow in student loans?

How much you can borrow depends on the type of student loan you’ve accepted. Federal student loans have annual and aggregate borrowing limits, depending on your year in school. Private student loan amounts are typically capped at your school-certified total cost of attendance, minus any financial aid you’ve already received.

Is a student loan worth it? 

Compared to other types of consumer debt, student loans are generally considered “good debt”. A 2023 College Board report found that completing college typically pays off over time, and leads to increased career prospects and earning potential in the long run.

Why are student loans so hard to pay off?

Interest, which is the cost of borrowing a student loan, can result in owing more toward your student debt than you originally borrowed. These interest charges can balloon over time. On top of that, the overall increase in everyday goods and services can make it more challenging to manage student loan payments each month.