How Do Student Loans Work? The Answer Might Surprise You
Student loans are one of the most popular financial products in the United States, as well as one of the most misunderstood.
Whether you are paying off your own student loans or helping your child navigate their college years, it is important to understand how the loan process works and how it will affect you over time.
In this article, we will answer some of the most common questions about student loans, including how they work and how they affect borrowers’ credit scores. We will also discuss their tax implications and help you figure out whether student loans are right for you at all.
What are Student loans?
Student loans are a form of financial aid that can help with the cost of higher education.
They are often given by the government, banks, or other lending organizations to students and their families who may not have the money necessary to pay for all four years of college.
In order to qualify for a student loan, you will need to fill out an application and provide documentation proving your eligibility (e.g., proof that you’re enrolled in school).
Types of Student Loans
There are four types of student loans: subsidized, unsubsidized, Perkins, and PLUS.
- Subsidized: A subsidized student loan is a type of federal student loan that requires no interest payments and has a below-market interest rate. Subsidized loans are available to students who demonstrate financial need, but not everyone qualifies. In order to qualify for this type of loan, your Expected Family Contribution (EFC) must be less than the cost of attendance at the school you are attending.
- Unsubsidized: Unsubsidized student loans are taken out by the student and interest accrues while they attend school. This is because these loans are not backed by the government, so they have to be paid back in full with interest. However, if you have received a grant or other type of financial aid that covers your tuition and you have to take out a loan, then your loan will be subsidized.
- Perkins loans: Perkins loans are a type of federal student loan. Unlike most other types of federal student loans, Perkins loans are only available to undergraduate students with exceptional financial needs. To be considered for a Perkins loan, you will need to fill out the Free Application for Federal Student Aid (FAFSA) and have an Expected Family Contribution (EFC) that is zero or less than 5%.
- PLUS: A PLUS student loan is a loan for parents of undergraduate students. Parents can borrow up to the total cost of attendance minus other financial aid. For example, if tuition and fees are $25,000, then your parent can borrow up to $25,000.
How Do Student Loans Work? Applying for Student Loans
The process for applying for student loans can differ depending on the type of loan you are applying for.
Generally, you will need to fill out an application that includes your information and your bank account details so they can verify how much money is in there.
There is also a credit check, which determines how risky it is to lend you money based on your history of repaying debt.
For example, if you have never borrowed money before and have no history of paying off any other debts like credit cards or student loans, then lenders might be wary because they don’t know if you will repay them or not.
If this is the case, then one option is to get a co-signer who has good credit and agrees to take on the debt with you if necessary.
Consolidating and Refinancing Student Loans
The first step in the process of refinancing your student loans is to consolidate all of your federal and private loans into one loan.
By doing so, you will likely reduce the monthly payment amount and shorten the term length.
Some lenders offer a variable interest rate that may change over time, while others offer a fixed interest rate that will not change for the life of the loan.
Once you have consolidated your loans, you can then shop around to find a lender with an attractive interest rate.
Repayment Plans for Student Loans
The Department of Education offers a number of repayment plans to help students manage their student loans. These include:
- Graduated Repayment Plan
- Income-Based Repayment Plan
- Income-Contingent Repayment Plan
- Pay As You Earn Repayment Plan (REPAYE)
- Income-Sensitive Repayment Plan
- Federal Perkins Loan Cancellation and Discharge Programs
- Student Loan Forgiveness
- Prepaid tuition plans
Forbearance and Deferment Options for Student Loans
Student loans can be a burden for many people. Luckily, there are two options that can help those with student loans get some relief: forbearance and deferment.
- Forbearance: A forbearance is an option where the borrower of a loan agrees to stop making monthly payments on the loan for a certain period of time (usually between three to twelve months).
- Deferment: A deferment is an option where the borrower does not have to make any payments on the loan for a certain period of time (usually up to three years).
Both of these options can help borrowers take a break from paying off their student loans without having to enter bankruptcy.
Loan Forgiveness Programs
To be eligible for loan forgiveness, you must work in a qualifying public service job, such as a teacher, law enforcement officer, or military personnel.
You must also have made 120 monthly payments (10 years) on your loans and have what is called an eligible loan.
If you have other types of federal student loans like Direct Unsubsidized Loans or Perkins Loans, they are not considered eligible.
Student loans can be a great way to help you get the education you want. However, it is important to understand the difference between federal and private loans before borrowing. Federal student loans are issued by the government and don’t require a credit check so they are easier to get, but they also come with more restrictions. Private student loans typically don’t have interest rates as low as federal ones, but they do not have the same restrictions that come with federal loans like repayment options or bankruptcy protections.