How Do Student Loans Work? A Step-by-Step Guide - The Scholarship System (2024)

Updated on July 4th, 2023

The idea of paying for collegeis stressful for students and their parents alike. Add to that the complexity surrounding financial aid packets and how federal student loans work, and it’s no wonder many people feel overwhelmed. To help you navigate through these mysterious waters, and provide you with some peace of mind, here is an overview designed to answer the questionhow do student loans work.

In this article, we will cover the different types of student loans, how they work, including interest rates and their impact on students’ payments, and explain how you can simplify your search for the best student loan options.

In no uncertain terms, student loans shouldn’t be your child’s first stop when it comes to paying for college. Free money, like grants and scholarships, are always preferable to loans.

Grants are often awarded based onyour student’s FAFSA, and they are given out on a first-come, first-serve basis to those who qualify. So, make sure they have theirs finished as soon as possible for each school year, or they could miss out on these excellent opportunities.

Scholarships are different. They are awarded based on criteria set by the organization sponsoring the scholarship. Additionally, the vast majority require students to apply directly to be considered. Application requirements vary, and some options are limited to applicants with specific criteria. However, there are a lot of them out there, so your child likely qualifies for more than they realize.

The best part about scholarships is that students can apply for them all the way through high school AND college years. So if your child needs loans for the first year, they could possibly secure scholarships for the following years and reduce the amount they need.

If you would like to learn more about how your student can score scholarships, join our free webinar for parents and students. It’s a great first step towards helping them avoid student loans.

What is a Student Loan?

You can’t answer the question, “how do student loans work,” without first understanding what a student loan is.

A student loan is a lending product designed specifically for college expenses. They are often easier to obtain than other forms of financing, like personal loans, as it’s generally well understood that incoming college students won’t have much on their credit reports.

Monies granted through a student loan are meant to handle costs like tuition, room and board, and possibly other educational requirements like books and supplies. How restrictive a loan is about how the money can be used depends on the exact type of loan involved and the rules set by the originator.

What is an Interest Rate?

Another important part of the “how do student loans work” question is understanding the interest rate.

The interest rate represents how much you will ultimately pay the lender for the ability to borrow funds. This is money owed on top of the principal. And it isn’t calculated just once. That’s why a $5,000 student loan with a 6 percent interest rate paid over 10 years won’t cost you $5,300 in total, but $6,661.

To explain how this happens, we must explain compounding interest a little bit. If that makes your head spin, bear with me. I explain it a little later under “unsubsidized loans.” There is even a video to help you out!

Another point I want to make is that, whenever graduates make a payment on a student loan, interest is paid first (like a mortgage.) Only the remainder is applied to the principal balance.

The Different Types of Student Loans

When you are working to understand the answer to the question “how do student loans work,” you need to understand the details about the different forms of loans available. Not all student loans are made equal. In fact, there are three primary types of student loans: federal subsidized, federal unsubsidized, and private.

Federal Student Loans

Subsidized federal student loans typically offer students the best deal. First, the interest rates are lower, saving your child money over the entire life of the loan. Second, interest isn’t assessed while your student is in school at least half-time. Third, there is a six-month interest-free grace period after they graduate. In the end, less interest means less owed.

Unsubsidized federal student loans still have favorable interest rates, but they don’t have all of the interest-free benefits of their direct subsidized loans counterparts. This means interest begins accruing almost immediately once the funds are disbursed, and it will cost more to borrow money this way in the long run.

Here is a simple video showing how unsubsidized loans accumulate interest before students even graduate.

It’s a simple, homemade video (nothing fancy!) but it was one of the most straight-forward in my opinion:

So based on this video, you will see that borrowing $10,000 per year, a total of $40,000 over the four years in college, ends up becoming a balance of $44,011.89.

Now here is the kicker:

That $4,011.89 in interest isrolled into the loan balance. So when the post-graduation payments are calculated, interest is going to be based on this NEW balance of $44,011.89 versus only the $40,000. It’s as if the student ‘borrowed’ that interest and therefore must pay interest on it (again.) As you can see, this snowball affect (compounding interest) ends up costing students a lot of extra money. Some loans will end upalmost doublethe amount borrowed by the time they are paid off.

Both subsidized federal student loans and unsubsidized federal student loans are issued by the government, and whether your student qualifies is based on their FAFSA information. The funds allowed is based specifically on your child’s tuition and annual maximums. No matter what, the loans will not exceed the tuitions costs, so these funds won’t pay for extras like laptops or transportation.

The student loan interest rates, associated with all federal loans, subsidized and unsubsidized, are set by the government. For undergraduate student loans disbursed between July 1, 2022, and June 30, 2023, the fixed interest rates are 4.99 percent for both kinds of loan. The government can change the interest rates for loans issued on or after July 1, 2023, but any loans disbursed prior to that won’t see their interest rates change. Essentially, once you have a federal student loan, that interest rate is locked in for the life of the loan.

Private Student Loans

Now that you have a solid understanding of the federal student loan portion of the “how do student loans work” question, it’s time to move on to private loans.

A private student loan is different. They aren’t issued by the federal government, so their terms and qualifications can vary depending on the lender. Often, it is best to view these as personal loans instead of student loans because, functionally, they are more similar to those than their federal counterparts. On a good note, the money provided might be usable for expenses beyond tuition and room and board. So, if your child needs things like a laptop, public transit passes, etc., these can help pay for those too.

Lenders set the rules on private loans they issue, so you want to shop around if you have to go this route. It is sometimes possible to find private student loans with lower interest rates than those offered by the government, but they typically require excellent credit to qualify. For most students with a limited (if any) credit history, that isn’t going to happen alone. The lender will probably need a cosigner, and the income and credit history and rating of that cosigner will have a strong impact on the rate assigned to the student loan borrowers themselves.

If your child can get all of their expenses handled with grants, scholarships, and federal student loans, it is often the better way to go in most cases. However, if these still leave your child short on the money they need, then private student loans are the next option.

Related Articles:

• How to Pay for Grad School Without Student Loans

1. Earnest*** – Charges no origination, application, prepayment, or late payment fees. We love minimizing fees!I also personally spoke with their team and found them so helpful and responsive which I think is a huge plus!

2. Ascent – Allows borrowers experiencing financial difficulty to enter temporary hardship forbearance for up to 24 months!

3. Sallie Mae – One of the most well-known, PLUS cosigners can be released after the borrower makes 12 consecutive on-time monthly payments. For parents who are consigning undergraduate loans, this is a major benefit.

4. Credible– Easiest to use

First and foremost, there are great resources to help you compare different student loan options. Using an online tool like Credible can simplify your search for student loans by showing you direct comparisons between different lenders. They are basically marketplaces, so you can shop around.

5. LendKey– Great comparison

One other private student loan source that came up often in my search is LendKey. They are often one of the lender options when you look into the loan comparison tools, so I thought we’d share some details on them as well.

One neat thing they mention is making small monthly student loan payments while in college. While this may sound challenging, it can be as little as $25 per month, which helps students avoid the scenario we described earlier, where interest builds up and is rolled into the principal once they graduate, thus increasing their loan payments exponentially. If a student can make these payments while in college, it would save them over $5,000 in the example we showed you. I was very impressed with Lendkey.

If you want to see what kind of offerings they have for your situation, you can fill out a quick application here:

Hopefully, with these options, you can shop around because it’s important you and your student hunt for the best deal!

More on that now…

Related Video: Best Private Student Loans of 2022

Determining how to select the best student loan deal is also part of answering the “how do student loans work” question.

As with any other loan, your child’s first step to finding the best option is to shop around like I mentioned. Why? Because the lowest interest rate might not be available at your current primary bank or other previous lenders.

If undergraduate students must borrow money, we always recommend subsidized loans first since they don’t start accumulating interest until students graduate. Next would be unsubsidized from the government. Third would be private student loans. While there may be exceptions, this order typically holds true.

Order of selecting student loan options (note: there may be exceptions depending on your family’s situation):

1. Subsidized loans
2. Unsubsidized loans via government (Related Video: Unsubsidized Loans Are They Worth It?)
3. Private student loans

So if you exhausted your options through FAFSA and the university, you can start with private student loans by using a comparison site likeSimple Tuition. These can display rates from multiple private lenders, allowing you to explore your options at a glance.

Your child also needs to look beyond the interest rate when assessing options. Things like loan origination fees, grace periods, deferment options, repayment plans, and borrower rewards can all change the affordability of a loan. For example, a 4 percent origination fee can hurt just as bad as a one percent interest rate hike. This means every cost and benefit needs to be considered to determine who truly offers the best value.

Overall, the key terms and figures you will want to know before borrowing include:

• Principal amount (borrowed)
• Interest rate
• Total cost for the life of the loan (principal plus total interest)
• Monthly payments upon graduating

And don’t forget to factor in money borrowed for the second, third and fourth (or fifth) years. You want to have a total picture for when they graduate and have to start repaying the loans.

At the bottom of this post, I put a calculator to help you see what kind of payments you are looking at.

Once the top few contenders have been identified, your student should apply to more than one lender. Since they won’t know exactly what rate they’ll be offered until they apply, there’s no better way to actually compare what option is the best without securing the offers.

Once your child secures their loans, they may be wondering how the money gets from the lender to the school. After all, it is a big part of how student loans work.

Well, in the case of federal loans, it’s pretty simple. Your student will have to identify the school they’ll be attending as part of the federal loan agreement. Then, when it comes time to pay the school, the money is sent directly to the college or university. This means your child doesn’t have to worry about coordinating that part of the payment process, as the disbursem*nts for that year happen on their own.

Private student loans offer more flexibility, so the money can come as a check or direct deposit into your child’s bank account. While this is convenient for covering those extra expenses, like the aforementioned laptop, it can leave the burden of paying tuition on your student’s shoulders if they don’t have other funds, such as federal student loans, covering those costs. So, that’s something to consider if your child is looking at paying tuition with private loans.

When Should You and Your Child Begin?

The final part of understanding how student loans work is learning how to decide when your student should start their loan search.

If your child is destined for college in the fall, and not all of their required funds have been gathered, then now is the time for them to get started searching for the right student loans. Otherwise, they may miss out if they can’t pay tuition on time.

Begin by looking through their financial aid packet and see what can be secured there and then determine if other options are needed. If so, it’s time to get them online to start the search.

If your child is younger than a senior, starting the hunt early spring of their senior year is ideal so that you have options.

What questions do you have regarding student loans? If so, post them below, and I will try to get them answered!

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Free webinar on how to secure third-party scholarships for college:

We always suggest exhausting all debt-free options like federal student financial aid before borrowing student loans. Did you know that it isn’t too late to apply to scholarships? Deadlines are as late as August for money for this fall. Join us on our next free webinar to learn more. https://thescholarshipsystem.com/freewebinar

Related Videos:

• Unsubsidized Loans Are They Worth It?
• Parent Plus Loan – Is It a Good Idea?
• Student Loan Interest
• Student Loan Cosigner: Is It A Must?

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