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How Do Student Loans Work

The average cost of college in the United States is over $35,000 annually per student. This includes tuition, books, supplies, and daily living expenses. This cost increases depending on the college you attend, the state you live in, and even the classes you decide to take. One of the best ways to prepare for college, is to figure out how you can finance your two to four years there. It may even be more years, if you go for a graduate degree or hope to get into medicine or law. 

There are a few ways in which you can finance your college education. You can apply for scholarships and grants. Use a college fund from your parents,if they have prepared one for you , or use student loans. Student loans are usually the only type of funding that you have to pay back at a later date. If you received a grant, scholarship, or money from your college fund then you won’t have to pay it back.

Finding the right funding for your education can be difficult, but getting a student loan is a viable option. This Scholaroo blog explains how student loans work.

What is a Student Loan?

Student loans are a type of financing for your college education. With a student loan, you could pay for your tuition fees, books, living expenses, and other related costs for the duration of your studies. When you get a student loan, you basically borrow money from a lender and pay that money back with interest at a later date. 

There are two types of lenders that offer student loans, namely federal student loans from the federal government; and private student loans, from banks, credit unions, and state loan agencies. If you plan on applying for student loans, here is everything you need to know and understand about your options and responsibilities for each. 

How Do Student Loans Work?

How Do Federal Student Loans Work?

Federal student loans are granted to students by the U.S government for college or trade schools. When you apply for financial aid, you may be offered loans as the financial aid offered by your school. A financial aid offer sometimes referred to as a ‘package’ is the total amount of financial aid (federal and private) that a student is offered by a college towards their education cost. 

There are four types of federal student loans available, these are known as Direct Loans: 

  1. A Direct Subsidized loan is offered to undergraduate students who demonstrate financial need, and need assistance with covering the cost of their higher education. If you are offered this loan, you won’t have to pay interest on the amount you borrowed.
  2. A Direct Unsubsidized Loan is for eligible undergraduate, graduate, and professional students without any consideration of their financial needs. With this loan you will need to pay the interest that has accrued on your loan while you are in college, otherwise, the interest is added to your loan balance. 
  3. A Direct PLUS Loan is made out to a graduate or professional student, or a parent of a dependent undergraduate student. The amount of this loan can be used to cover any education expense that is not covered by any other financial aid. The eligibility for this loan is based on credit checks. To qualify, the borrower must not have an adverse credit history. If they do, they will have to meet additional requirements to qualify. The interest on your PLUS loan accrues once the loan is fully disbursed. The repayment can be deferred while the student is in college and for six months after graduation. 
  4. A Direct Consolidation Loan permits you to combine all your federal student loans into a single one, with a single loan service. A loan servicer is basically a company that collects payments and maintains your federal student loan on behalf of a lender. 

There are a few benefits with each of your direct loan options with federal loans that you should take note of. Firstly, with these loans, your interest rates are typically lower and fixed. Secondly, you can borrow money without a co-signer for these loans. Thirdly, you can arrange a repayment plan that would start six months after you leave college and is flexible. Lastly, your loan can be forgiven, if your work is in a profession such as teaching or another public service profession. 

How it works: To apply for a federal student loan you need to fill out and submit the Free Application for Federal Student Aid (FAFSA). This application will determine the kind of loan you will be offered and how much you can borrow. If you are an undergraduate student, the maximum amount you can borrow each year in Direct Subsidized Loans and Direct Unsubsidized Loans ranges from $5,500 to $12,500. If you are a graduate or professional student, you can borrow up to $20,500 annually. You can also make use of the Direct Plus loan to cover additional college costs. 

How Do Private Student Loans Work?

Private student loans are typically available to students through banks, financial institutions, credit unions, and online lenders. Lenders will use their own standards for borrower requirements. If you are planning to finance your college education with a private student loan then having a good credit score of 670 or higher, will get you the most competitive rates and terms. It is usually better to take up a federal student loan first for your studies, but if you need more money to cover the total cost of your education then this is a great option to fill the gap. 

As an undergraduate student, you may not be able to borrow from a private lender independently, you will require some sort of co-signer to qualify. This is because you will most likely have a shorter credit history. Some private lenders will approve a loan without a co-signer, but here are a few things you should be aware of. 

  • There is little flexibility in the repayment options. With such loans, you may not have loan terms to choose from, just one standard one that you must accept when you accept the loan. 
  • There are stricter limits on how much you can borrow. You will only be able to take out a smaller amount. 
  • Interest rates tend to be higher for non-cosigned loans. When you have good credit, you may qualify for a private loan at an interest rate that is quite low, but without it will most likely be higher. 
  • There are typically added fees that add to your loan cost, that you should be aware of. 

Adding a co-signer to your loan will improve your chances of qualifying with a lender and securing lower interest rates. Friends, relatives, and parents are typically skeptical of being someone’s co-signer because any missed payments on your end will affect their credit. You can make them more comfortable by signing a co-signer release program, this is a program that allows you to remove the co-signer from your loan after you have made a certain number of payments. 

A co-signer release program is something you want to arrange before accepting any loan offer. Also, note that you can only apply to remove your co-signer if you meet the lenders’ eligibility requirements. Some requirements may also include that you must also personally have a better credit portfolio. 

How it works: Applying for a private student loan is easy, you just need to approach a bank or some financial lender and submit an application. They will typically have consultants who can assist you with the process. You may need to prepare some of your usual documents such as your proof of address, social security number, and that of your co-signer, as well as college admission letter amongst other documents. You want to make sure that you understand all the terms of your loan before accepting the offer. With a private student loan, you want to pay close attention to the interest rates. 

Understanding Interest on a Student Loan

When you borrow from a lender it is important to understand how the interest on the amount you borrow works. Because you will not just pay back the money you borrowed but the interest too. The interest is added to the total loan amount that you must pay. 

Your monthly loan payments will include 1) a payment to reduce the balance on the amount you borrow and, 2) a payment to reduce the balance on your interest.

Here is an example: Let’s say you graduate with a student loan of $28,400 with a 4,66% interest rate and a 10-year loan term. The total lifetime cost of your student loan would be $35,583 paid over 10 years, and not $28,400. You will pay back the total student loan + the interest accrued on the loan over the years. Your monthly loan payment will include both payments towards reducing the principal balance of the loan amount you borrowed, and the interest payments too. However, don’t be alarmed because the repayments are worked out to be a manageable amount for you, and you can always try to pay extra in your monthly payments to finish paying off your loan sooner. 

More things you should know about interest rates on your student loan: 

  • The higher the interest rate the more interest you will pay every month.
  • A higher interest rate increases the overall cost of your loan. 
  • Choosing a longer repayment term will likely give you a higher interest rate.
  • Your interest rate largely depends on your credit score.
  • Interest on a student loan generally compounds monthly, meaning that the amount you will pay in a given month is based on the remaining loan amount. 
  • You can get either a fixed or variable interest rate on your student loan. 
  • You can also refinance a student loan to a fixed or variable interest later on. 
  • Interest rates from private lenders are often not fixed.
  • A good interest rate depends on the interest rate market at the time you apply, try comparing any interest rate offered by a private lender to the federal student loan rate. This will help you see if it is a good interest rate, that is similar to or better for a private loan. 
  • As the principal balance goes down, the amount you pay in interest will also go down.

Fixed and Variable Interest Rate Explained

With a fixed interest rate the rate remains the same for the lifetime cost of your loan, regardless of changes in interest rates, repo rates, etc. in the economy. This means that your monthly payments will remain the same for the duration of your repayment period. 

Variable interest rates mean that the interest rate can change over time as market rates go up and down. So for the lifetime cost of your loan, the amount of your monthly repayments will fluctuate according to the interest rates too. If you have a long-term loan, say 10 years, this kind of interest rate may be unideal. They can become more expensive in the long run, because of unpredictable changes in the market rates. If you have a short-term repayment period on your loan then this type of interest rate could be beneficial, instead of fixing the interest rate at a rate that is quite high, which you are obligated to pay. You can instead, benefit from the changes in the market rates and save money. 

One last thing to understand about interest rates on your student loan is that you can reduce the amount you pay in interest in two ways. First, you can either make extra payments towards your loan to pay it off sooner, by reducing the amount on the loan you will end up paying less monthly. Second, you can refinance your student loan to a loan with a lower interest rate. This is mostly beneficial with a private student loan. With a federal student loan, you miss out on so many of the benefits such as loan forgiveness, income-driven repayment options, deferment solutions, or even discharge from your loan due to death or disability. 

To conclude, you should note that preparing for your future means that you should be extra cautious when making decisions about borrowing money. Using a student loan is a great option for financing your college education but you should seek out advice on different student loans before committing yourself. This should not be a stressful process for you at all. Try to enjoy this step of preparing for your future. This Scholaroo blog has explained to you how student loans work, and provided an understanding of the different types of loans you can get, how interest rates on your student loans work and how to apply for loans.  

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