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Understanding Student Loans: How Do Student Loans Work?

Student loans are complex, but we break down how they work.

Justin Cupler

Contributing Writer at Tally

March 17, 2022

Getting a higher education typically means taking out student loans. Doing so can be a process, since there are lots of nuances you need to know before taking out a student loan. Having a full understanding of how student loans work ahead of time can help you along the way.

Below, you’ll get answers to the question, "how do student loans work?" — so you can make educated decisions about how to fund your higher education. 

How do student loans work? 

There are many things to understand about student loans, from the various types of student loans there are to their interest rates and repayment terms. Let's dive into the world of student loans to give you a firm idea of how student loans work. 

What are the types of student loans?

There are two main types of student loans: federal and private. 

Federal student loans

Federal student loans are among the most common loans students get. These loans are offered directly from the federal government and have many benefits to make a college education easier to afford. 

There are four main types of federal student loans, also known as direct loans: 

  1. Direct Subsidized Loans: Direct Subsidized Loans are for undergraduate students who've demonstrated a financial need via the Free Application for Federal Student Aid (FAFSA). These loans help students cover higher education or trade school costs. 

  2. Direct Unsubsidized Loans: Direct Unsubsidized Loans are for undergraduate, graduate and professional students who need money beyond what they qualify for under the Direct Subsidized Loan program. These loans are not based on financial need.

  3. Direct PLUS Loans: Direct PLUS Loans are for graduate or professional students and parents of dependent undergraduate students. These loans will pay for any expenses other financial aid offerings don't cover and aren't subject to financial need. There is, however, a credit check for this loan — the only federal student loan with this requirement. 

  4. Direct Consolidation Loans: You will likely end up with multiple loans with various loan servicers throughout your college years. The Direct Consolidation Loan allows you to combine these loans into one — streamlining your repayment process. 

Private student loans

Private student loans are a second option for funding your higher education and can come from various sources such as banks, credit unions and online lenders. It’s wise for students to attempt to maximize their federal student loans before resorting to private ones. Federal student loans are easier to secure, generally have lower interest rates and include unique benefits many private student loans don't. 

Private student loans often require a credit check, making them challenging for students without an established credit history to get. Fortunately, lenders will often approve loans with a cosigner. There are some no-credit-check student loan lenders, but these are the minority and often have a higher interest rate. 

How much can you borrow?

College can be quite expensive, so there's often anxiety as to whether or not you have enough federal student loan eligibility to cover the cost. 

The maximum amount undergraduates can borrow is up to $57,500 in total federal student loans, but only $23,000 of that can be in subsidized loans. Graduates and professional students may take out up to $138,500 in federal loans and only $65,000 may be in subsidized loans. 

These are only the aggregated totals. The federal government also sets limits every year. The yearly value increases as you get deeper into your studies and varies based on whether you're a dependent or independent student

The annual limits are as follows: 

  • Undergraduate year one: Dependent students can take out up to $5,500 in total federal student loans, and $3,500 of that can be subsidized. Independent students can take out up to $9,500 in total federal student loans, and $3,500 of that can be subsidized.

  • Undergraduate year two: Dependent students can take out up to $6,500 in total federal student loans, and $4,500 of that can be subsidized. Independent students can take out up to $10,500 in total federal student loans, and $4,500 of that can be subsidized. 

  • Undergraduate year three and beyond: Dependent students can take out up to $7,500 in total federal student loans, and $5,500 of that can be subsidized. Independent students can take out up to $12,500 in total federal student loans, and $5,500 of that can be subsidized. 

  • Graduate and professional students: Graduate and professional students are considered independent and can take out $20,500 in unsubsidized federal student loans per year.

Private student loans, on the other hand, have significantly higher limits and generally max out at your college's cost of attendance, minus the financial aid you received.

What can you spend student loans on?

Federal student loans have strict limitations on what you can use your loans on. These include:

  • Tuition and associated education fees

  • Room and board

  • Groceries

  • Textbooks and other school supplies

  • Computers

  • Costs associated with studying abroad

  • Transportation to and from school

  • Child care expenses while in school

Private lenders will have their own limitations, but they usually fall under similar guidelines

If you spend your student loans on unapproved items, there’s a chance your lender will cancel your account and demand immediate repayment. 


What are the repayment terms?

For federal student loans, the standard repayment term is up to 10 years and you must pay a minimum of $50 per month. If you have a small student loan, $50 per month could cover the entire loan balance before the 10 years are up. 

The one exception to this rule is a Direct Consolidation Loan, which you can repay for 10 to 30 years and requires a minimum payment of $50 per month. 

Federal student loans also have alternative payment arrangements for specific situations. These are known as income-driven repayment plans

There are four income-driven repayment plans available, and their specifics are as follows: 

  • Revised Pay As You Earn Repayment Plan (REPAYE Plan): You pay 10% of your discretionary income — the difference between your annual income and 150% of the poverty guideline in your state for your household size — as your monthly payment for 20 (undergraduate) or 25 (graduate and professional students) years

  • Pay As You Earn Repayment Plan (PAYE Plan): You pay 10% of your discretionary income as a monthly payment for no more than 10 years

  • Income-Based Repayment Plan (IBR Plan): For loans created after July 1, 2014, you pay just 10% of your discretionary income until the loan is paid off or for 10 years, whichever is shorter. For loans created on or before July 1, 2014, you pay 15% of your discretionary income until the loan is paid off or for 10 years, whichever is shorter

  • Income-Contingent Repayment Plan (ICR Plan): You pay either 20% of your discretionary income or a fixed payment that would result in a 12-year repayment, whichever is less

Private student loans have a wide array of repayment options depending on the loan provider. These can range as short as five years or stretch as long as 15 years. 

What will the interest rate be? 

Federal student loan interest varies based on the type of loan you have. 

Through July 1, 2022, the federal student loan interest rates are as follows:

  • Direct Subsidized Loans and Direct Unsubsidized Loans for undergraduates: 3.73%

  • Direct Unsubsidized Loans for professional and graduate students: 5.28%

  • Direct PLUS Loans: 6.28%

Private student loans are a different breed because they're based on your credit rating and other variables. With a great credit score and credit history or a cosigner with those attributes, you may secure a private student loan with a lower interest rate than a federal student loan. 

Private loans also come in two interest categories: fixed and variable. 

  • With a fixed-interest-rate student loan, the interest rate remains the same throughout the life of the loan

  • With a variable-interest-rate student loan, the interest rate can change periodically — monthly, quarterly, yearly, etc. 

On average, private student loans carry a 6% to 7% interest rate, but they can climb as high as a 12.99% annual percentage rate (APR). 

Do you have to repay loans while you're in school?

Federal student loans have a wide range of deferment and forbearance options to help those who cannot afford their monthly payments. These start with an in-school deferment for students who attend school at least half-time. If you're in graduate or professional school and have a Direct PLUS Loan, you get an additional six-month grace period after leaving school. 

The in-school deferment is automatic in many cases. 

As for private student loans, in-school deferment varies by lender. Check your loan terms and confirm the deferment options before signing any loan documents.

Can I delay my loan payments for other reasons? 

Federal student loans have other options that allow you to temporarily reduce or stop your monthly payments beyond the in-school deferment. 

One option is a deferment. The deferment options include:

  • Cancer treatment deferment

  • Economic hardship deferment

  • Graduate fellowship deferment

  • Military service and post-active-duty deferment

  • Parent PLUS borrower deferment

  • Rehabilitation training deferment

  • Unemployment deferment

While in deferment, all unsubsidized loans or unsubsidized portions of loans will accrue interest charges. 

There are also forbearance options on federal student loans. The majority of forbearances are not automatic and the borrower must request it. 

General forbearance is what you'd request if you ran into financial difficulty, unexpected medical expenses, a change in your employment situation or any other reason your student loan servicer deems acceptable.

Loan servicers can grant general forbearance for up to 12 months at a time, but you can renew it when it expires. However, you're only allowed a total of three years of forbearance. 

There are also several mandatory forbearances. If you fall into any of these categories, your loan servicer must grant you forbearance: 

  • You enlist in AmeriCorps service

  • You qualify for the Department of Defense Student Loan Repayment Program

  • You're in a medical or dental residency

  • You're in the National Guard and are activated by a governor

  • Your monthly student loan payment is 20% or more than your monthly income

  • You are working as a teacher in a role that qualifies you for student loan forgiveness.

When your loan is in forbearance, interest will continue to accrue regardless of the type of student loan you have. You can choose to pay the interest as it accrues or allow the servicer to capitalize it and add it to your principal balance. 

Like the in-school forbearance, private student loans' other deferment and forbearance options vary by loan servicer. Check with your servicer to find out what options they have.

Understanding how student loans work sets you up for success

Before heading to college and diving into student loan debt, it's smart to understand how student loans work. This will set you up for successful student loan use and repayment. It also helps you understand your options — including forbearance and deferment — if you get into a financial bind and can't make your payments. 

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