Updated: Jul 21
This is the time of year where all families are trying to figure out how to pay their college bills. So my next few posts will be about student loans.
If you are like most people and don’t have enough money to pay for college, a student loan will enable you to borrow money and pay it back at a later date, with interest. College loans are like any other loan that you may borrow in that you’ll have to repay the principal with interest, though some offer more favorable repayment terms than others. Interest rates, loan terms, and fees can all impact how much you need to pay over the entire life of any student loan. Let’s dive into how student loans work.
When you’re borrowing for college it’s important to understand what you’re agreeing to repay.
Types of Student Loans
There are two main types of lenders that offer student loans to college students. The U.S. government offers federal student loans. Banks, credit unions, state loan agencies and other financial institutions offer private student loans.
Be careful, as some of the lenders that offer private student loans also service federal student loans on behalf of the U.S. government, so it is easy to get confused. That’s why it’s important to understand the different types of loans and how student loans work.
Federal student loans are loans that are made by the U.S. government. It’s a good idea to take out federal loans first because these loans are less expensive and usually come with more benefits than loans from private lenders.
The advantages of a federal loan over a private loan include:
Fixed and lower interest rates
The ability to borrow money without a cosigner.
Repayment plans that start six months after you leave college or attend less than half time
The last two are the primary reasons that I will usually recommend a Federal Student Loan rather than a Private Loan. If you qualify, you may save thousands, tens of thousands, and even more. You may have your entire loan obligation forgiven! Be warned that this is a very complex area. In my opinion the most complex area of college financial planning. to read more click here
There are four types of federal student loans for college:
Direct Subsidized Loan: Subsidized Stafford loans, also known as direct subsidized loans, are available to undergraduate students with demonstrated financial need. While enrolled in college at least half-time and for six months after you graduate or drop below half-time enrollment, you won’t have to pay interest on the amount you borrowed. This can be a huge cost savings.
Direct Unsubsidized Loan: Unsubsidized Stafford loans are available to undergraduate and graduate students, regardless of financial need. Unlike subsidized loans, you will need to pay the interest that has accrued on your loan while you are in college, or the interest will be capitalized (added to the loan balance).
Federal Direct PLUS Loan: Grad PLUS and Parent PLUS loans are available to graduate students and parents of dependent undergraduate students. PLUS loans aren’t subsidized, so interest will start accruing as soon as the loan is fully disbursed. Repayment can be deferred while the student is enrolled in college and for six months after graduation.
Federal Direct Consolidation Loan: Consolidation loans allow you to combine multiple federal student loans into one loan, without losing the benefits of the federal loans. Consolidation can be used to streamline repayment or to switch loan servicers.
For a more detailed explanation of these loans click here
Private student loans are loans that come from a private lender, usually a bank, a credit union, a state loan agency or a non-bank financial institution. Private loans can come with fixed or variable interest rates and often require the student borrower to have a cosigner. Private student loan interest isn’t subsidized, so as soon as you borrow money the loan will begin accruing interest. The truth is searching for the right Private Student Loan is worse than searching for a mortgage. There are so many different loans and bells-and-whistles to each loan it is almost impossible to find the perfect loan and your mind will go numb spending hours searching.
Federal Student Loans Versus Private Student Loans
Federal student loans are made by the U.S. government. A federal loan, such as federal direct loan, will have a lower interest rate than a private loan. Federal loans also typically offer more favorable terms, flexible repayment plans and loan forgiveness options.
Here are some key differences between a federal student loan and a private student loan:
Congress sets the interest rates for federal student loans, which are typically lower than interest rates for private student loans. Private student loan interest rates are set by the lender and are based on the borrower’s credit worthiness. These loans may have a variable interest rate or a fixed interest rate. Variable rates may start out lower, but they will fluctuate over time based on economic conditions.
Just about anyone can get a federal direct student loan. The Department of Education requires a credit check for federal PLUS loans, but you may still be able to qualify even if you have an adverse credit history. Private student loans, on the other hand, always require a credit check and may also require a cosigner if you don’t have establish credit.
Some federal loans, such as a direct subsidized loan, are based on financial need. Other federal student loans, such as a federal direct unsubsidized loan, are not based on financial need, but there are limits as to how much you can borrow. Private student loans are not based on financial need.
The only way to get a federal student loan is to file the FAFSA and accept the loan on your financial aid award letter. Borrowers must submit the FAFSA by a certain deadline for each year that they need help paying for college. But you can apply for a private student loan at any time throughout the year.
With a private loan, you are borrowing from a private lender. With a federal loan, you are borrowing money from the government. However, once the government disburses the funds they will assign the loan to a loan servicer to manage the account. The loan servicer is who you would contact if you wanted to change your repayment plan, apply for forbearance or deferment or update your contact information.
You can refinance a private student loan to another private student loan with a lower interest rate or a better repayment term. You cannot, however, refinance a federal student loan into another federal student loan, although you can refinance your federal student loan into a private one. That means once you refinance a federal student loan, you give up government protections like student loan forgiveness options. To keep your federal benefits, you might consider consolidating your loans into a direct consolidation loan.
How Interest Works for Student Loans
Because you’re not just paying back the amount you borrow, you’re paying back interest as well (just like credit cards), it’s important to understand how much that will add to the total amount you pay.
How much you pay in student loan interest depends on a number of factors: whether your loan is subsidized or unsubsidized, the interest rate on your loan, the amount you borrow, and the loan term.
For example, you graduate with a $10,000 loan with a 5% interest rate and plan to pay it off over 10 years. You will pay $2,728 in interest over the 10 years that you repay the loan. Your monthly loan payment will include both payments to reduce the principal balance (the amount borrowed) and interest payments. The total amount repaid will be $12,728 including both principal and interest.
Interest generally continues to accrue during forbearances and other periods of non-payment. So, if you take a break from repaying your loans or skip a loan payment, the total cost of the loan will increase, and not just because of late fees.
Loan payments are applied to the loan balance in a particular order. First, the payment is applied to late fees and collection charges. Second, the payment is applied to the interest that has accrued since the last payment. Finally, any remaining money is applied to the principal balance. So, if you pay more than the minimum each month, you will make quicker progress in paying down the debt. There are situations where you should ONLY pay the minimum amount due.
The interest rates for federal subsidized and unsubsidized loans are determined by Congress, and rates vary for different types of loans. They are set July 1st of each year.
For the 2022-2023 academic year,most likely increasing for the (2023-2024 year) interest rates that student loan borrowers need to pay are:
Direct subsidized and unsubsidized undergraduate loans: 4.99%
Direct unsubsidized graduate loans: 6.54%
Direct PLUS loans (for parents or graduate and professional students): 7.54%
For private loans, lenders set an interest rate based on your individual situation, such as your income and credit history.
How to Pay Less Interest
You can reduce the amount you pay in interest by making extra loan payments to pay it off sooner or by refinancing your student loan to a loan with a lower interest rate. However, refinancing federal student loans into a private loan means a loss in many benefits – income-driven repayment options, possible loan forgiveness or widespread forgiveness, generous deferment options, and a death and disability discharge.
How Much You Can Borrow Through Student Loans
Because you will have to pay back the money that you borrow with your student loans for college, only borrow what you really need. The loan amount that you can borrow depends on the type of loan. For federal loans, your college will determine the amount of money that you can borrow, but there are some limits:
Undergraduate Federal Direct Stafford Loans: The borrowing limits are from $5,500 to $7,500 per year for dependent undergraduate students and $9,500 to $12,500 per year for independent students, depending on your year in school. Aggregate limits between $31,000 and $57,500 also apply.
Graduate Federal Direct Stafford Loans: The borrowing limit is up to $20,500 per year for graduate and professional students, with aggregate limits of $138,500, and up to $40,500 per year for medical school students.
Private Loans: The maximum amount you can borrow from a private lender varies. Most lenders don’t let you borrow more than your college’s cost of attendance minus other financial aid.
Direct loans are also subject to aggregate loan limits, meaning there’s a maximum on the total amount that you can have in outstanding loans. The borrowing limit for Federal Direct PLUS loans is generally the remainder of the cost of college not covered by Federal Direct Stafford loans and any other financial aid.
Expenses You Can Use Student Loans For
Federal subsidized and unsubsidized student loans can be used to pay for most expenses associated with your college education, such as:
Room and board
Meal plans or groceries
Books and supplies
Computers and other needed technology
How private student loans work and their exact terms can vary depending on the lender. While most are very similar to federal student loan allowances, some may put different limitations on the expenses you can pay with the loan funds.
Costs of Student Loans
The total amount you’ll need to pay over the life of your student loan includes not only the principal and interest but also loan fees. All federal loans are subject to loan origination fees: these are around 1% of the loan amount for direct subsidized and unsubsidized student loans, and around 4% for direct PLUS loans.
Private student loans may also have origination fees, though these are normally built into the interest rate. They may also be subject to other kinds of charges, such as late payment fees.
Let’s take a look at some examples of how much a student loan costs over the course of the full repayment time period, based on different APY ranges. (The APY is the annual interest rate plus fees, taking into account the impact of compound interest over time.)
Total Loan Amount
Total Cost Of Loan
Direct Subsidized Loan