Did you know that approx 68% of students have student loans? Furthermore, 46 million Americans actively owe on their student loans. And for most of us, student loans are the only way to afford college. But with all that said, many people aren’t sure exactly how these loans work, what deferment is, or how much interest they’re being charged on their loan.
It’s not uncommon to meet someone paying on their loans a decade after their last class. It’s important to understand how student loans work to minimize and manage your payments and stay ahead of infamous student loan debt. Here’s everything you need to know.
What Are Student Loans?
Student loans are loans designed to help people pay tuition and college-related expenses. They come with interest charges, due dates, and associated fees like any loan. The amount a student qualifies for depends on some combination of academic success, enrolled hours, credit score, if there’s a cosigner, and overall income.
Most people use multiple student loans and scholarships to afford college. And as you can imagine, student loans are a big responsibility. Luckily, the more you know about student loans, the better.
How Federal Student Loans Work
Every individual student loan comes with a different set of terms and conditions. This means you have different interest rates, amounts, and terms. Before we get started, here are some words you should know.
Annual Percentage Rate: Also known as APR, an annual percentage rate refers to the interest you’ll pay each year on your loan.
Loan Term: Loan term is how many months you have to pay back your loan. The loan term is typically expressed in months or years. I.e., 24 months, 2 years, etc.
Principal Balance: Principal balance is the amount you initially borrowed and are paying towards.
Minimum Payment: The minimum payment is the least amount of money that must be paid to the loan each month. Minimum payments are typically 1-3% of the overall loan balance, but this can vary. Most of the minimum payment goes toward the interest charges, and a portion goes towards the principal balance. Paying above the minimum payment means more money goes towards the principal balance. Some loans may have restrictions on how much you can pay in a month.
Deferment: Deferring means delaying your payments until an agreed-upon date.
Balloon Payment: Balloon payments occur after a deferment, payment plan, or as final payment to “satisfy” the loan. Unlike voluntarily paying more than the minimum, a balloon payment is built into the contract and must be met; otherwise, you’ll accrue added interest and/or fees.
Prime Rate: Interest rates are based on two things – the interest rate you personally qualify for and the prime rate. The prime rate is a minimum APR decided by the government and based on the economy. As of the writing of this article, the prime rate is 3.5% which means no loans have an APR lower than 3.5%. Keep in mind that reputable lenders base their interest on the prime rate. Comparatively, predatory lender/ shady lenders don’t use the prime rate, which almost always means they lock you into an APR far higher than a traditional lender. For clarification – the lower the APR, the better.
Fixed-Rate: Fixed-rate means the APR will remain the same for the life of the loan.
Adjustable Rate: An adjustable rate means the APR can fluctuate throughout the loan term. It can go higher or lower but will typically increase by the end of the loan.
Types of Federal Student Loans
Direct Consolidation Loan: A consolidation loan is a loan made to pay off all of or a bulk of your existing loans. It’s beneficial to anyone tired of making multiple monthly payments to various organizations. It can also lower the overall interest you pay annually. A common requirement for this loan is that the borrower can’t open any new loans until the consolidation debt has been paid in full.
Direct Subsidized Loan: A direct subsidized loan is one of the most popular loans because it defers payment until schooling is over. And there’s a post-graduation grace period until payments are due. These loans are tailored toward those that need financial help. Plus, interest payments are handled by the government until you’re ready to pay.
Direct Unsubsidized Loan: Direct unsubsidized loans have no built-in grace period, and the interest accrues immediately.
Direct PLUS Loans: Direct PLUS loans can be used for tuition, but they’re most commonly used to purchase items, classes, and other items that aren’t covered by existing student loans. A variation of this loan is a Parent Direct PLUS Loan which is available to parents of college students.
How Interest Works
The concept of interest goes back as far as bartering and money itself. The basic principle is that you borrow an amount and, over time, pay back a little more than you borrowed due to interest. Exactly how it works is a little more complicated.
You can calculate a close approximation of interest by doing: Principal balance x Interest x Loan Term or Interest = P x I x LT
For example, let’s say you have a loan for $2,000 with an interest rate of 11.23% and a loan term of 24 months. In that case the arithmetic is, 2000 x 0.1123 x 2 = $449.2 in total paid interest.
How Federal Loan Repayment Works
The most common method of paying back a loan is over time with monthly payments. You can also make lump-sum payments when possible. However, as mentioned above, some loans limit how much you can pay per month. Also, some loans have a prepayment fee in which you’ll be charged a fee for paying the loan off too early. It’s good to determine if your potential loan has one or both of these stipulations.
Most people take years to pay off their student loans. But beware, it’s easy to fall into the idea that loans will always be available to you, but this isn’t always the case. One factor in whether or not you’ll be approved for a loan is your debt to income ratio or DTI. DTI is how much money you have coming in vs. how much you have going out. For example, if you have a monthly income of $1,000 but your bills total $800, your DTI is 80% – which is high. Most lenders prefer a DTI of 40% or less.
Here’s why that’s really important in the long run. Most people with multiple loans have a high DTI, a prerequisite for financial ruin. A high DTI can make you especially tied to your paycheck. Imagine having multiple loan payments and then experiencing reduced income.
How to Get Federal Student Loans
The first step to getting a student loan is Free Application for Federal Student Aid, also known as FAFSA. FAFSA is a bit of a tedious process, so be prepared to spend a few hours on it. Qualification for a federal student loan isn’t guaranteed. The most common reasons for denial are:
- Owing to a prior government loan
- Poor academic performance
- Incorrect information
- Not enrolled for enough hours
- Legal issues
How Private Student Loans Work
Private student loans encompass literally any non-federal student loan. As such, they have unique terms and require a credit check to qualify for. Here’s what you need to know.
Types of Private Student Loans
- Degree Specific: Private loans that must be used for a specific degree.
- Income Share: Income share means that a person pays a percentage of their income instead of a set monetary amount for a minimum payment.
- Bad Credit Loans: These are private student loans tailored to those with low credit scores.
- State Student Loans: State student loans are loans only available to long-term residents of a state. For example, MEFA is the Massachusetts Educational Financing Authority, a student loan available to state residents.
How Interest Works
Interest for private student loans works the same way as other loans. However, private student loans may have higher interest depending on the lender.
How Private Loan Repayment Works
Loan repayments also work the same as federal student loans. However, private student loans may not have deferments built into the contract.
How to Get Private Student Loans
You can apply for private student loans in-person or online. Remember that private student loans are based on personal credit and may require a cosigner to improve interest and approval odds.
A good rule of thumb is to apply for federal loans first and then move on to private loans.
How Much Money You Can Borrow
There’s a limit to how much an individual can borrow, based on your time in school and dependency status.
|1st Year – Dependent
|1st Year – Independent
|2nd Year – Dependent
|2nd Year- Independent
|3rd Year – And Beyond -Dependent
|3rd Year – Beyond Independent
|Unsubsidized Loan Limit – Dependent
|Unsubsidized Loan Limit – Independent
How Much Money You Should Borrow
The general rule of thumb is to only borrow as much as you can pay back and/or need. That said, it’s better to take out one large sum that you know will go towards tuition than to borrow multiple small loans.
What Happens If You Can’t Afford Your Monthly Payments?
If you can’t afford your monthly payments, call your lender and request to defer or set up a new payment plan. If you don’t give them notice, then it’s a guarantee that you’ll accrue late fees and higher interest on future loans.
You can also apply for a consolidation loan to lower your overall payment amount.
How to Avoid Student Loans
There are only two ways to avoid student loans. Option A is to pay for college entirely with your own money. Option B is not to go to college at all. Keep in mind that college isn’t for everyone. If you’re unsure if college is for you or what you really want to do with your life, it’s okay to figure things out more time. You’ll be paying on student loans years after you take them out. This is why it’s important that you’re able to make the most of them.
Books and Resources to Learn More About Student Loans
One of the best resources to learn about student loans is studentaid.gov. Beyond that, there are a few good books to learn more
Anthony Oneal’s Destroy Your Student Loan Debt
Anthony Oneal’s best-selling student loan debt book is chock full of great advice to combat debt. It takes a blunt approach to really educate readers about the ins and outs of paying off debt quickly.
Daniel J. Mendleson’s Bye Student Debt
BYE student debt offers a lot of actionable solutions to paying off debt. It also helps a person develop the right mindset to be successful in other financial areas.
Adam S. Minsky, Esq – Student Loan Debt 101
Student Loan Debt 101 goes into detail about the nuances of student loans. It is also a quick read at only 54 pages.