How Do Student Loans Work? Explained!

For many people, student loans are the first debt they’ve ever had to deal with, and they’re not quite sure how the loans work. With federal loans, the money you borrow gets sent straight to your school’s financial aid office. 

Private loans may send the money to the school or to the borrower, who then has to pay the school. When loan proceeds are paid directly to schools, they apply the funds to tuition, fees, and possibly room and board. If any money is leftover, that goes to the student. 

Most undergrad student loans come with ten-year terms, meaning you have ten years once you leave school (plus a six-month grace period in most cases) to pay them back. All student loans come with interest, but how that interest adds up depends on the type of loan you have.

Different Types of Student Loans

There are two main categories of student loans: federal and private. The vast majority of student loans are federal, making up about 92 percent of the total (according to MeasureOne). Federal loans cover around forty-three million borrowers for $1.4 trillion (as of December 2018). Private loans are much less common, making up 7.63 percent of total student debt for a total of $119 billion.

Federal Loans

Federal student loans often come with lower interest rates, better loan terms, and much more payment flexibility. The interest rates on these loans are fixed (they stay the same over the whole life of the loan) and determined by Congress. 

In most cases, students (even those without any credit history) won’t need cosigners or credit checks (except for PLUS loans) to secure federal loans. With most federal loans, you won’t have to start paying them back until after a six-month grace period once you’ve left school (for any reason). 

In some cases, interest will begin accruing from the day your loan is disbursed, even if you’re not required to begin making payments yet. You’ll get a schedule from your lender or loan servicer spelling out when that first payment is due along with how much and how often you’ll need to make payments.

Learn more about how Federal student loans work.

Private Loans

Private student loans are just what you’d think: loans offered by private lenders like banks, credit unions, and sometimes schools. The specific lender sets the loan terms, so there’s a lot of variation among private loans. 

Interest rates tend to be higher than those on federal loans (sometimes almost as high as credit card rates). Also, many private loans come with variable interest rates, which means the interest rate and the monthly payment may fluctuate over the life of the loan. 

Private loans require credit checks and frequently call for cosigners. Another key difference with private loans is that you may have to start making payments while you’re still in school. 

Other private loans follow the federal model, though, and allow for a six-month payment grace period after you leave school. Read through your loan documents carefully to make sure you understand exactly when and how you need to begin repaying your loans.

How Do Student Loans Work?

Like other kinds of debt, student loans come with some basic common factors: loan balance, interest rate, loan term (how long you have to pay it back), and repayment schedules. From there, student loans (especially federal loans) behave differently than other debt. 

Student loans start with your financial award letter when you decide to accept loans as part of your payment to the school. From there, you sign loan documents that include all the rules governing your loans and your promise to repay them as stated. 

This is where many students (and some parents) get hung up: They sign without fully understanding how the loans actually work.

When Interest Starts

One of the most important things to know about your student loans is exactly when the lender will start charging interest (also referred to as when interest starts accruing). Most student loans start accruing interest the day the loan gets disbursed, and the borrower is responsible for paying that interest. 

The main exception comes with federal subsidized loans, where the government picks up the tab for any interest that builds up while you’re not expected to be making payments (while you’re still in school or during deferment periods).

When Payments Start

You won’t have to start making payments on most federal and some private student loans until six months after you leave school. Some federal loans, including parent PLUS loans, may call for payments to start right away. 

Check with your loan servicer to find out your first payment date to make sure that you don’t miss it. If your loans are unsubsidized, interest starts accumulating right away. That interest gets added to your loan balance, so you owe more by the time payments officially begin. 

You can make payments to cover that interest (or at least a portion of it) even though you’re not required to, and that will help keep your student loan debt from ballooning. 

Once you’re required to start making payments, do it. If you don’t make your payments on time, your loan will be delinquent, and you’ll be charged late fees. If you stop making payments, your loan will go into default, and that will have a long-lasting effect on your credit and your finances. Learn more about how to pay student loans.

Grandparents with Student Loans

Older adults (age fifty and up) owe $289.5 billion in student loan debt, according to the American Association of Retired Persons (AARP). That’s due to a combination of borrowing for others (like children and grandchildren) and extended repayment periods on their own student loan debt.

Learn more about how to reduce student loan debts.

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