How Do Student Loans Work

Last Updated on May 19, 2022

How Do Student Loans Work?

Student loans are a way to finance your higher education. But how do they work, and why should you apply for one? Here’s everything you need to know about student loans!

What are student loans?

Student loans are a type of loan that allows students to pay for their education at a college or university. The loan is repaid with interest once the student graduates, enters the workforce, and starts earning an income. A student loan is different from a personal loan because it is issued by a bank or other financial institution and has certain requirements for repayment.

How Do Student Loans Work? - College Ave

How Do Student Loans Work

If you don’t have the money to pay for college, a student loan will enable you to borrow money and pay it back at a later date, with interest.

College loans are different from a grant or scholarship. If you receive a grant or a scholarship you’re not borrowing that money. That is money that has been given to you as a gift and doesn’t need to be repaid.

What Types of Student Loans are Available?
There are two main types of lenders that offer student loans. The U.S. government offers federal student loans. Banks, credit unions, state loan agencies and other financial institutions offer private student loans.

Be careful, as some of the lenders that offer private student loans also service federal student loans on behalf of the U.S. government, so it is easy to get confused.

Federal loans
Federal student loans are loans that are made by the U.S. government. It’s a good idea to take out federal loans first because these loans are less expensive and usually come with more benefits than loans from private lenders.

The advantages of a federal loan over a private loan include:

Fixed and lower interest rates
The ability to borrow money without a cosigner
Repayment plans that start six months after you leave college or attend less than half time
Flexible repayment plans like income-driven repayment and extended repayment
There is also the possibility that some of your loans can be forgiven — that is you don’t have to repay them — if you work in certain professions, such as teaching and public service
There are four types of federal student loans for college:

Direct Subsidized Loan
Subsidized Stafford loans are available to undergraduate students with demonstrated financial need. While enrolled in college at least half-time and for six months after you graduate or drop below half-time enrollment, you won’t have to pay interest on the amount you borrowed. This can be a huge cost savings.

Direct Unsubsidized Loan
Unsubsidized Stafford loans are available to undergraduate and graduate students, regardless of financial need. Unlike subsidized loans, you will need to pay the interest that has accrued on your loan while you are in college, or the interest will be capitalized (added to the loan balance).

Federal Direct PLUS loan
Grad PLUS and Parent PLUS loans are available to graduate students and parents of dependent undergraduate students. PLUS loans aren’t subsidized, so interest will start accruing as soon as the loan is fully disbursed. Repayment can be deferred while the student is enrolled in college and for six months after graduation.

Federal Direct Consolidation loan
Consolidation loans allow you to combine multiple federal student loans into one loan, without losing the benefits of the federal loans. Consolidation can be used to streamline repayment or to switch loan servicers.

Private loans
Private student loans are loans that come from a private lender, usually a bank, a credit union, a state loan agency or a non-bank financial institution. They can come with fixed or variable interest rates and often require the student borrower to have a cosigner. Interest isn’t subsidized, so as soon as you borrow money the loan will begin accruing interest.

How Does Interest on a Student Loan Work?
Because you’re not just paying back the amount you borrow, you’re paying back interest as well, it’s important to understand how much that will add to the total amount you pay.

How much you pay in interest depends on a number of factors: whether your loan is subsidized or unsubsidized, the interest rate on your loan, the amount you borrow, and the loan term.

For example, you graduate with a $10,000 loan with a 5% interest rate and plan to pay it off over 10 years. You will pay $2,728 in interest over the 10 years that you repay the loan. Your monthly loan payment will include both payments to reduce the principal balance (the amount borrowed) and interest payments. The total amount repaid will be $12,728 including both principal and interest.

Interest generally continues to accrue during forbearances and other periods of non-payment. So, if you take a break on repaying your loans or skip a loan payment, the total cost of the loan will increase, and not just because of late fees.

Loan payments are applied to the loan balance in a particular order. First, the payment is applied to late fees and collection charges. Second, the payment is applied to the interest that has accrued since the last payment. Finally, any remaining money is applied to the principal balance. So, if you pay more each month, you will make quicker progress in paying down the debt.

You can use a loan calculator to help you calculate exactly how much you’ll pay in interest.

How to Pay Less Interest
You can reduce the amount you pay in interest by making extra loan payments to pay it off sooner or by refinancing your student loan to a loan with a lower interest rate. However, refinancing federal student loans into a private loan means a loss in many benefits – income-driven repayment options, possible loan forgiveness or widespread forgiveness, generous deferment options, and a death and disability discharge.

do student loans have interest

To better understand how student loan interest works, let’s start by defining what “interest” means.

Interest on a loan of any kind – college, car, mortgage, etc. – is, essentially, what it costs to borrow money. It is calculated as a percentage of the principal (the amount you borrow), and this percentage is what’s known as your interest rate.

How does student loan interest work when paying back your loans?

Student loan interest rates can be fixed (unchanging for the life of the loan) or variable (fluctuating throughout the life of the loan). In both cases, the lower the interest rate, the less you’ll owe on top of the principal, which can make a big difference in the total amount you’ll owe on your loan over time. Federal loan interest rates remain fixed for the life of the loan. Private student loans vary by lender, but most lenders offer both variable and fixed interest rates.

A student loan is often a long-term commitment, so it’s important to review all of the terms of your promissory note (sometimes called a credit agreement) before signing. This note is just how it sounds – an agreement or promise you make to pay back your loan within the parameters laid out by your lender.

Terms in a credit agreement include:

  • Amount borrowed
  • Interest rate
  • How interest accrues (daily vs. monthly)
  • First payment due date
  • Payment schedule (how many payments – or “installments” – it will take to pay back the loan in full)

Your student loan will not be considered repaid in full until you pay back both the principal and the interest. To better understand how these costs combine, let’s dive into some common questions about student loan interest.

Your interest rate is determined by your lender. In most cases, if you’re considered a riskier candidate (and many students are, simply because they lack credit histories and steady incomes), the loan can be more expensive by way of a higher interest rate. To help secure a lower interest rate, students often apply with a cosigner. It might be difficult, but it’s not impossible to get a private student loan without a cosigner.

This applies more to private student loans than federal student loans, which have a separate application process that does not always consider the credit worthiness of applicants.

How is interest calculated on federal student loans?

Federal student loans, which are issued by the government, have a fixed interest rate (unchanging for the life of the loan), which is determined at the start of the school year. The rate determination is set in law by Congress.

Federal student loans and simple daily interest

Federal student loans adhere to a simple daily interest formula, which calculates interest on the loan daily (as opposed to being compounded monthly).

Since federal student loans are issued annually (and they don’t calculate your yearly balance for you), it’s fairly simple to calculate the amount of interest you’ll owe that year. Just take your annual loan amount (the principal), multiply it by your fixed interest rate, then divide that amount by 365:

Principal x Interest Rate / 365
Example:$5000 x 5% / 365 = 0.68 (68 cents per day will accrue on this loan)

With these stabilized variables, interest on federal student loans can be easier to calculate and predict than interest on private student loans. However, since both types of loans might be required to cover costs, it’s a good idea to understand how interest works on both.

How is interest calculated on private student loans?

Private student loans, which are issued by banks, credit unions, and other non-government entities, can have either fixed or variable interest rates, which can fluctuate during the life of a loan.

Student loan interest rates can vary from lender to lender, to get a better understanding, let’s take a look at an example.

If your loan balance is $2,000 with a 5% interest rate, your daily interest is $2.80.

1. First we calculate the daily interest rate by dividing the annual student loan interest rate by the number of days in the year.
.05 / 365.25 = 0.00014, or 0.014%

2. Then we calculate the amount of interest a loan accrues per day by multiplying the remaining loan balance by the daily interest rate.
$20,000 x 0.00014 = $2.80

3. We find the monthly interest accrued by multiplying the daily interest amount by the number of days since the last payment.
$2.80 x 30 = $84

So, in the first month, you’ll owe about $84 ($2.80 x 30) in monthly interest. Until you start making payments, you’ll continue to accumulate about $84 in interest per month.

Be sure to keep in mind that as you pay off your principal loan balance, the amount of interest you’re paying each month will decrease.

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