How Do Student Loans Work?

Quick Answer

Student loans allow you to finance your college education. Students can get student loans from the federal government or private lenders and repay them once they're finished with school.

A stack of student loan cash sits on top of a blue graduation cap.

Student loans can help you pay for some or all of your college education with borrowed money from the federal government or a private lender.

If you're considering student loans, it's critical that you understand what you're getting into and how educational debt can impact your financial future. Here's what you need to know.

How Do Student Loans Work?

Student loans are a specialized type of loan you can use for approved education-related expenses. Both college students and their parents can take out student loans to help pay for college costs. Student loans are available from the federal government as well as private lenders.

When a student or parent takes out a student loan, the lender disburses the loan directly to the educational institution to pay for tuition and fees. If there's money left over, the student will receive a student loan refund, which they can use to pay for other eligible education expenses, such as:

  • Textbooks
  • Supplies
  • Computers and software
  • Equipment necessary for class
  • Room and board
  • Transportation

If the student is taking out the loan, they typically don't need to start making payments until after they graduate, leave school or fall below half-time enrollment. However, parent loans typically start the repayment process immediately.

Depending on which type of loan you receive, repayment options can vary. But like other types of loans, student loans charge interest and may also come with some fees attached.

Types of Student Loans

Federal and private student loans are both available for college students and their parents. But while they both can help you pay for college, they differ in a handful of ways.

Federal vs. Private Student Loans
Federal Student Loans Private Student Loans
Eligibility Students and parents who meet the Department of Education's eligibility criteria Students and parents who can meet the lender's credit requirements
Interest Interest rates are fixed and standardized for all who qualify Interest rates can be fixed or variable and are based on the applicant's creditworthiness
Fees Typically charge an upfront loan fee, which is disbursed from the loan amount, as well as late fees Typically don't charge upfront fees but may charge late fees
Repayment options Standard repayment term is 10 years, but that can be extended up to 30 years; income-driven repayment plans are available Repayment terms typically range from 10 to 25 years
Benefits Eligible for student loan forgiveness programs, income-driven repayment plans and generous forbearance and deferment options May offer a lower interest rate or low fees for especially creditworthy borrowers

With both federal and private student loans, there are different loan types that serve specific purposes.

Types of Federal Student Loans

There are four different types of student loans the Department of Education offers to students and their parents:

  • Subsidized student loans: Subsidized loans are available to undergraduate students with financial need. Interest that accrues on these loans while the student is in school and during future deferment periods is paid by the federal government.
  • Unsubsidized student loans: These loans are available to undergraduate, graduate and professional students, and financial need is not a factor in determining eligibility. Interest begins accruing immediately on unsubsidized loans.
  • Direct PLUS loans: These loans are available only to graduate and professional students. They typically come with higher interest rates and loan fees than unsubsidized loans but have higher loan limits.
  • Parent PLUS loans: These are the only loans that parents of college students can take out to help their child pay for school. Their interest rate, fee and limits match direct PLUS loans.

There are also other loan programs, including Perkins loans and family federal education loans, but those programs are no longer available to new applicants.

Types of Private Student Loans

Private student loans can also come in different forms, depending on which lender you choose. Here are some of the types you may come across:

  • Undergraduate loans
  • Graduate loans
  • Post-graduate loans
  • Parent loans
  • MBA loans
  • Law school loans
  • Medical school loans
  • Dental school loans
  • Bar study loans
  • Residency loans
  • Career training loans

Depending on your situation, search for private lenders that offer loans that fit your needs.

How Does Student Loan Interest Work?

Interest rates can work differently depending on the type of loan you have. Here's how it breaks down between federal and private loans and what to keep in mind with your loans.

Federal Student Loan Interest

Interest rates on federal student loans are standardized for all who qualify, and they're set by Congress each year. For the 2021-22 school year, those rates were:

  • Undergraduate loans: 3.73%
  • Graduate direct loans: 5.28%
  • Direct PLUS loans for students and parents: 6.28%

Interest rates on federal student loans are always fixed, which means they don't change throughout the life of the loan. Additionally, you may be able to secure a discount on your interest rate if you sign up for automatic payments.

While students don't need to begin making loan payments until six months after graduation, leaving school or falling below half-time enrollment, interest will accrue on federal student loans from the date of the disbursement, except in the case of subsidized loans.

If you don't pay the accrued interest before your first loan payment is due, it will be capitalized when your repayment plan begins and added to your principal balance. As a result, it's a good idea to make interest-only payments while you're in school, if possible.

Once you begin making monthly loan payments, a portion of your payment will go toward the interest that's accrued since your last payment, and the remainder will go toward your loan balance.

Private Student Loan Interest

Private student loan interest rates are set by individual lenders, which typically offer a range of rates based on your creditworthiness.

Depending on the lender, you may be able to choose between fixed and variable interest rates. While fixed rates stay the same, variable interest rates can fluctuate with market rates. Variable rates typically start off lower, making them more appealing—but because variable interest rates can rise in the future, it's best to avoid them.

As with federal loans, interest on private loans accrues from the date of disbursement and can be capitalized and added to your loan balance when you finish school, so consider interest-only payments while you're in college.

Once you start making payments, a portion of your payment will go toward accrued interest and the remainder will reduce your loan balance.

How to Apply for Student Loans

The application process for federal and private student loans is different. Here's what you need to know:

  • Federal student loans: If you don't already have one, you'll need to create a Federal Student Aid ID. Then, you'll be able to fill out the Free Application for Federal Student Aid (FAFSA). You'll provide information about yourself, the schools you want to receive your application, details about your parents' finances (if applicable), as well as your own financial situation. Your school will use this information to determine your eligibility for federal loans and other forms of financial aid.
  • Private student loans: Most private lenders allow you to get prequalified without a hard credit inquiry. Do this with a handful of lenders so you can compare interest rates, repayment terms and other features. Then you'll apply directly with the lender of your choice online. You may need to provide some documentation, such as pay stubs, tax returns, a government-issued ID and more. The lender will underwrite the application and give you an offer based on your creditworthiness, which you can accept or decline.

Remember, if you get approved for student loans, the lender will send the money to the school first, then you'll receive anything that's left over to use for other approved expenses.

How to Pay Off Student Loans

Depending on the type of loans you have, there may be several different ways you can pay off your student loans. If you have private loans, you're stuck with the repayment plan that you chose when you first applied unless you decide to refinance your loans with another private lender.

However, if you have federal student loans, you'll have more options:

  • Standard repayment plan: This is the 10-year plan everyone with federal student loans starts with.
  • Income-driven repayment plans: The Department of Education offers four income-driven repayment plans that reduce your payment to 10% to 20% of your discretionary income and extend your repayment plan to 20 or 25 years. After you've completed your term, any remaining balance will be forgiven.
  • Extended repayment plan: If you have more than $30,000 in direct loans, you can extend your repayment plan to up to 25 years. Monthly payments can be fixed or graduated, which means they start out low and increase over time.
  • Graduated repayment plan: With this option, payments start out low and increase over time, typically every two years, ensuring that your loans are paid in full by the end of 10 years.
  • Consolidation repayment plan: If you consolidate your federal loans, you can choose a repayment term ranging from 10 to 30 years.

What Happens if You Can't Pay Your Student Loans

Missing a student loan payment can result in late charges and damage to your credit score. If you let your loans go into default, you may also be on the hook for collection charges and even more damage to your credit score. As a result, it's important to know your options:

  • Deferment or forbearance: Deferment and forbearance allow you to pause your student loan payments for a set period, typically just a few months at a time, while you get back on your feet. That said, interest typically continues to accrue unless you have federal subsidized loans on a deferment plan.
  • Income-driven repayment: Consider one of these plans if you can afford a lower monthly payment on your federal loans.
  • Forgiveness: The federal government offers a couple of loan forgiveness programs for public servants and teachers. Research the Public Service Loan Forgiveness and Teacher Loan Forgiveness programs to get more information and to see if you're eligible.
  • Loan repayment assistance: There are many federal and state agencies that offer loan repayment assistance. Depending on the program, you could get tens of thousands of dollars in aid. Also, student loan repayment programs are becoming more popular among private employers.

Use Your Student Loans to Build Credit

Making regular on-time payments on your student loans can help you establish a good credit history over time. If you can afford it, making interest-only payments while you're in school can help you avoid capitalized interest and also build your credit history.

But even if you wait until after you leave school, those payments can help you achieve your credit goals. As you work to build your credit history using your student loans and other credit options, use Experian's free credit monitoring service to track your progress with access to your FICO® Score and Experian credit report.