How do student loans work?

What is a student loan?

With a student loan, you borrow money to cover the expenses of a post-secondary education, including tuition, fees, books, supplies and living costs while at school.

But student loans must eventually be paid back, meaning you’ll start out your life after college in debt.

The upside is that student loans can help you afford college. They also can help you build your credit rating, if you handle them well.

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Having a single loan to pay off makes it easier to manage your payments, and you can often get a better interest rate than what you might be paying on credit cards and car loans.

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How do student loans work?

Student aid for school comes mostly in the form of scholarships, grants and loans. But while scholarships and grants are basically free money, student loans must be repaid — with interest — except in rare circumstances.

To determine whether a loan will be necessary, students should fill out the Free Application for Federal Student Aid, or FAFSA, to see if they qualify for government grants and some scholarships. The form asks for detailed financial information from the student, and often the parents, too.

If financial aid won’t go far enough, then it may be time to turn to student loans, which come either from the federal government or private lenders, such as banks or other financial institutions.

Federal loans can offer the kinds of benefits that many borrowers have taken advantage of during the COVID-19 pandemic, including payment freezes, interest waivers and even loan forgiveness. Private loans often come with competitive interest rates and higher borrowing limits.

The government allows students to wait until after graduation to start repaying federal student loans, while many private lenders require payments to be made while a student is still in school.

The types of student loans

The federal government and private lenders offers several varieties of college loans to students and their parents.

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How much can you borrow?

The amount you can borrow from the federal student loan program is determined by your year in school and whether you are dependent on your parents. Financial need also may play a role.

An undergraduate typically can access anywhere from $5,500 to $12,500 per academic year. If you are a grad student, you may qualify for up to $20,500 a year. The lifetime federal student loan limits are $57,500 for undergraduates and $138,500 for graduate or professional students.

The amount you can borrow using a private student loan is based on the lender’s assessment of your ability to pay the loan back.

Student loan interest rates

Federal student loans offer fixed interest rates, announced every July, that do not change during the loan's lifetime. Interest accrues daily.

Note that the interest on federal loans has been frozen at 0% since the early days of the pandemic in 2020, and is scheduled to stay that way until May 1, 2022.

But, through June 30, 2022, these are the underlying rates on student loans from the U.S. government:

• 3.73%: Direct loans for undergrads.
• 5.28%: Direct loans for graduate or professional students.
• 6.28%: Direct Plus loans for parents, and for graduate or professional students.

The interest you pay on a private student loan is usually higher than for a government loan. However, if you have a good credit score or a strong banking relationship, you might negotiate a lower rate.

How student loan repayment works

How quickly you pay off your student loan is dependent on your financial situation. In 2022, the average student loan payment is $460 per month, and it takes the average borrower 20 years to repay the debt, according to the Education Data Initiative.

Repayment terms for private student loans are set by the lender. Federal student loans offer several repayment options.

• The standard repayment plan is the default, and is available to all borrowers. Payments are fixed, with the goal of paying off the loans within 10 years.
• The graduated repayment plan also is available to all borrowers. Payments start low, then increase every two years, also so the loan is paid off in 10 years.
• Extended repayment plans are available if you owe more than $30,000 in direct loans. Payments can be either fixed or graduated, so that you pay off your loans within 25 years.
• Revised pay-as-you-earn repayment plans (REPAYE) are available to all direct loan borrowers. Monthly payments are limited to 10% of your discretionary income and are recalculated yearly based on your income and family size. If you have an outstanding balance after 20 years (for undergraduates) or 25 years (for graduates), the government will forgive that debt.
• Pay-as-you-earn repayment plans (PAYE) are available to all direct loan borrowers. Monthly payments amount to 10% of your discretionary income but will never be more than you'd pay under the standard repayment plan. Payments are recalculated every year based on income and family size. Outstanding balances that remain unpaid after 20 years are forgiven.
• Income-based repayment plans are for borrowers with high debt-to-income ratios. Monthly payments amount to either 10% or 15% of discretionary income but are never more than you'd pay under the standard repayment plan. Payments are recalculated annually based on your income and family size. Outstanding balances are forgiven after 20 or 25 years, depending on when the loan was taken out.
• Income-contingent repayment plans are an option for all direct loan borrowers. Monthly payments are the lesser of 20% of discretionary income or the amount you would pay on a repayment plan with fixed payments over 12 years, adjusted for income. Payments are recalculated every year, and any outstanding balance owed after 25 years will be forgiven.

If you're struggling to repay your student loans, you can request forbearance or deferment. These can postpone payments on your student debt for up to 36 months.

But they're not great options, even if you qualify. Interest will likely be added to your debt, making your student debt load even larger, except in rare instances such as the loan relief offered during the COVID emergency.

You also might consider refinancing your federal student loans through a private lender. In the wake of the pandemic, student loan refinance rates have been hitting all-time lows.