How college student loans work: The definitive guide to borrowing responsibly, to minimize your student loan debt

The average college graduate comes away with a degree–and $29,000 of student loan debt, requiring an average monthly loan payment of $393. That ends up being a really high percentage of new graduates’ salaries, so perhaps it’s no surprise that, in 2018, 20% of student borrowers were behind with their payments. The problem is: once you’re behind, it can be even easier to get more behind. 

We’re here to help you figure out how to not let that happen to you. How do student loans work? How do you know how much you can afford to borrow? How do you choose the right (cheapest, most flexible) loan? And how do you best manage the costs? 

We’ll get into all that, and more.

The basics: How do student loans work?

First off: What is a loan?

A loan is money you borrow and have to pay back. Usually, you have to tell your lender what you’re planning to use the money for. In this case, since you’re using it for college, these are student loans. (There are also business loans, car/auto loans, etc.)

What does it cost?

If you’re loaned $1000, this $1000 amount is called your principal. When you repay a loan, you have to pay back your principal (original borrowed amount), plus interest (basically, a fee for borrowing it). Generally, this interest rate is indicated as a percent per yearー but in practice, this is divided into monthly payments.

In addition to interest, some loans also have an origination fee or disbursement fee, which is a one-time charge for creating your loan. This is sometimes a dollar amount, or more often a percentage of the loan amount.

How long do you have to pay it back?

Your repayment term is the length of time (for example, 10 years) that you have to repay the loan. Generally speaking, the longer your repayment term, the lower your monthly payments, but the more you’re paying in total over time. (This is because you’re still paying that annual interest rate, but for more years!)

Who gives you the money for a student loan? 

Depending on your financial need, the government might lend you some money. However, that might not be enough, so some students also take out “private student loans” from private, for-profit companies like Earnest. This isn’t always a bad idea, but you do have to be careful with your total loan debt. With our free Insights product, we’ll help you figure out if your student loan debt is too much. 

Can you give me an example?

Sure, we can! So let’s take the Federal Direct Subsidized Stafford Loan as an example. Under its standard repayment plan, these are the loan terms:

  • Interest rate: 4.53% fixed
  • Origination fee: 1.06%
  • Repayment term: 10 years
  • Minimum monthly payment: $50

Based on this, if you borrowed $3500, here’s what your loan would look like:

  • Borrowed: $3500
  • Total paid over 10 years: $4123.29
  • Interest paid over 10 years: $623.29 ー This is effectively what you paid to borrow that original $3500!

That’s a lot right? Loans (even the “best” ones from the federal government) are expensiveーwhich is why we recommend generally limiting them as much as possible. 

For more help understanding your college finances, we recommend using our free Insights product. You can compare financial aid packages from different colleges, get estimates on future salary and monthly debt payments, and get a reading on the overall affordability of each college. 

What’s the difference between government loans and private loans?

Loans are offered by the federal government or by private companies. 

There are three main types of federal student loans:

  1. Direct Subsidized Loans (also known as Stafford Subsidized Loans)
  2. Direct Unsubsidized Loans (also known as Stafford UnsSubsidized Loans)
  3. Parent PLUS loans (also known as Direct PLUS Loans)

The first two (the Direct Stafford types) are generally loans with very good terms, better than what you’d find elsewhere from private companies. So if you need to take out loans, always max out your offers of these first.

Unfortunately, after accepting 100% of your Direct Stafford loans, you might still have a financial gap.

In that case, you should consider Parent PLUS loans as well as private loans (like this one). Parent PLUS loans are designed to be more similar to offers you might find elsewhere, so they’re not always better. 

For more information on federal student loans, we have a full article on how those work

How much can I borrow in student loans? 

For federal loans, the limits are: 

  • Direct Stafford Loans (subsidized & unsubsidized): $5500 first year, $6500 second year, $7500 third year and beyond
  • PLUS loans: Your cost of attendance, minus any other financial aid

Private loans will all have their own rules for maximum amounts. For instance, Earnest provides loans of $1000 up to the total cost of attendance. 

That said, remember that just because you can borrow a certain amount does not mean you should do so. You should always consider whether you can afford to repay those loans later on. 

Using our free Insights tool, you can calculate your college costs, your financial gap, and whether you can afford to take our loans to fill that gap. 

How much can I afford in student loans?

How much you can afford to borrow in student loans really depends on what your after-graduation salary will beーin particular, what your debt-to-income ratio is. This ratio is your monthly repayment amount, divided by your monthly salary. And a good rule-of-thumb is to keep it at a maximum of 10%.

For example, if my monthly loan repayment is $400, then to keep within this 10% rule, I’d need to earn at least $4000 per month (about $48,000 per year) to be able to make those payments. Of course, earning more than this would make it even easier to repay my loan!

This ratio is why it’s important to assess your financial aid package (including the loans), alongside your likely salary after graduation. We can help you do exactly that with our free Insights product. We look at government data to estimate your future salary, to then calculate whether your loan burden is too high. 

What’s the average national student loan interest rate?

First, a primer on interest rates: Fixed vs. Variable

Most student loan providers will allow you to choose whether you want your loan with a fixed rate or a variable rate. So really, we need to phrase the questions as: 

  • What’s an average (or good) FIXED student loan rate?
  • What’s an average (or good) VARIABLE student loan rate? 

And, of course, what’s the difference? 

  • A fixed rate means it never changes. All government loans are fixed. For example, a Federal Direct Subsidized Stafford Loan has a fixed rate of 4.53%. Every year for the entirety of your loan term (usually, 10 years), you will pay this 4.53%. It doesn’t matter if interest rates go up or down after you take out the loan. Generally, for this “security” or knowing your rate, you will be charged a higher (at least initially!) rate than if you choose variable. 
  • A variable rate fluctuates with the performance of the economy. It  is usually quoted as a percent on top of some common financial rate, for example LIBOR (the interest rate that banks use to lend to each other in London). So for instance, if you have a variable loan rate of 3.00% + LIBOR, and the current LIBOR rate is 0.44%, then your interest rate right now would be 3.00%+0.44%, or 3.44%. However, if the LIBOR rate rises (usually because the economy is doing well), then your student loan interest rate will rise too. 

Now that you understand the difference between them, which is better? Well, it depends. 

  • Generally, the fixed rate is the “safer” bet. It gives you a dependable monthly payment (that remains the same), which means easier planning. 
  • The variable rate is better if you think you’ll be repaying the loan quickly, since your initial interest rate will be lower. Also, if you think the economy is about to take a turn for the worse, this is the better option because your rates will decrease as interest rates go down. 

Okay, now back to your regular programming.

What’s a good interest rate? 

Student loan rates differ widely based on your (or your co-signer’s) credit score. That said, in surveying the rates of nine popular lenders for May 2020, here’s what we found: 

Average (of ranges)8.23%6.60%

A while ago, the Credible loan marketplace did an analysis for May 2017-2018 and found that the average 10-year student fixed-rate loan (with immediate repayment) was 7.64%. 

So in summary, a very good rate is pretty close to 4% (fixed) and 1.5% (variable). An average loan is likely 7%-9% (fixed) and 5.5%-7.5% (variable). That said, remember to shop around and find the lowest rate for you. Most lenders will allow you to get a rate estimate (like this one from Earnest). 

Generally, asking for many lines of credit can lower your credit score. But there’s a time-limited exception for student loans! If you request all these estimates within about two weeks, the credit bureaus will “de-duplicate” these requests, so that they will be counted as one request, meaning your credit score won’t take a knock. Just remember to be proactive and get those estimates all around the same time! 

How do student loan payments work?

Many student loans offer you the option to defer some or all of your payments to after you graduate. Some also provide you with a “grace period” of 3-9 months after graduation, to find a job and get financially settled. During this “grace period,” interest still accrues (continues being added), but you aren’t required to make a payment. 

Once your repayment period starts, you’ll need to make monthly payments on your student loans. If you have multiple federal loans, you can consider consolidating them to give yourself one easy payment (but, warning: this might increase your total repayment amount). If you have federal and private loans, then you will need to make these payments separately.

You can use loan calculators like the government one here  to estimate your monthly payments. Otherwise, you can sign up for our free Insights product, and we can figure out your total student loan payments for you (across federal and private loans!).

In general, it’s better to pay as much as you can, as early as you can. This allows you to pay off all your student loan debt faster, meaning you will be paying interest for fewer years. If you repay your loans before the end of your term, you end up paying less money overall. 

However, at the very least, it’s important to make your monthly payments. Many lenders have late fees or nonpayment penalties, so you can end up racking up an even higher bill if you skip your payments. 

Should I make payments while I’m still in college?

Yes, if you can afford to. Most student lenders will allow you to defer all payments until after you graduate, but your loan will still accrue interest, which then gets capitalized every month or quarter. Let’s walk through an example to see what these technical terms mean. 

To simplify the math, let’s say I borrow $1000, and each month, my interest is $10. 

  • If I pay $10 each month, then at graduation, my total balance is still $1000 because I’ve been paying off the monthly interest as it gets added. 
  • If I pay more than $10, then I am paying off my monthly interest and paying down my original principal (borrowed amount) of $1000. So if I pay $15 in month 1, then in month 2, I only need to pay interest on the $995 remaining balance! 
  • If I pay less than $10, then this amount gets added to my balance (“capitalized”) and then the interest is calculated based on the new, higher balance. So if I don’t pay anything ($0) in month 1, then in month 2, my balance is $1010, so my interest will get calculated on that (I’ll now owe more than $10.10 just in interest.) 

This example uses small numbers, so maybe an increase in $0.10 doesn’t seem so bad. But Earnest gives a great, transparent example of why this matters for larger sums: For a $10,000 loan over 15 years, at 13.03% interest rate, here’s what your total repayment (over the life of the loan) would look like, under different repayment schemes while studying:

  • Full monthly payments while in college: $22,828
  • Pay only monthly interest for 4 years: $28,187
  • Defer payments (pay $10) for all 4 years: $34,874

The difference between paying at least interest, and paying nothing, is a whopping $6,687.

Of course, for some students, it’s just not financially feasible to pay anything while studying. That’s understandable, but it’s important to at least understand the financial implications of that. 

How do I compare student loan terms to find the best one?

We’ve got a list of questions you can research or ask any lender. Just sign up for our free Insights product, which will help you better understand your college costs, get a forecast of your future salary, and pick the right loan offering. 

Any tips on managing (or lowering) my loan costs? 

Yep! Here are four ways to lower the overall loan cost of your loan (what you’re paying over the full repayment period): 

  1. Fill out the FAFSA. Since federal student loans generally have better interest rates than private student loans, you want to maximize those first. And the only way to be offered them is to fill out your FAFSA. (Incidentally, you might get some federal grant money that way too!) 
  2. Apply for external scholarships. Winning scholarships will mean you don’t have to take out as much money in loans. You can sign up for Going Merry or another scholarship website, to get a personalized list of scholarships you can apply for. Most of these will require essays, so here’s some help for that.  
  3. Make (small) payments while in school. As discussed above, it can save you a lot of money in the long-term if you can make payments (ideally covering at least your monthly interest) while you’re in school. Many students work a part-time job during college, or work during the summers, so remember to earmark some of those earnings for your loan payments!
  4. Consider refinancing later on. After you graduate, if you have a stable income, you might be eligible to refinance your loans, which means combining all your federal and private student loans into one single loan, with a lower interest rate. Lenders are willing to offer you a lower rate because rather than being a credit-risky student, you’re now a more financially secure, salary-earning adult! 

Federal student loans: What are the different types, How much can you borrow, and What are your repayment options

If you see any kind of federal student loan (Direct, Stafford, or PLUS) listed in your college’s financial aid award package/letter, then you might be wondering: What are they? How do they work? We break it all down for you here.

What are federal student loans? 

Federal student loans are loans from the government to individuals, to support at least half-time study at the undergraduate or graduate level. You must be working towards a degree or certificate. 

There are three types of federal student loans: 

  1. Direct Subsidized Loans (also known as Stafford Subsidized Loans)
  2. Direct Unsubsidized Loans (also known as Stafford Unsubsidized Loans)
  3. Parent PLUS loans (also known as Direct PLUS Loans)

The first two are always given directly to the student, who then must repay the loans after graduation. The last one (PLUS loans) are given to parents of undergraduates; only graduate students may directly get PLUS loans. Parent PLUS loans cannot later be transferred to the student’s name; it will legally remain the parent’s financial obligation to repay.

Note that sometimes people colloquially call these federal loans “Department of Education loans” or “FAFSA loans,” which refers to this same group of loans. 

What’s the difference between Direct Subsidized loans, Direct Unsubsidized Loans, and PLUS Loans? Which one is best?

These three types of federal loans are very different!

Direct subsidized loans are the most affordable ones.

They have the lowest interest rates. Interest also doesn’t accrue (get added) during college. This means that if you borrow $3000 in Year 1 (and nothing after), then when you graduate, your loan balance will still be $3000 and you’ll only need to pay interest on that. 

Direct UNsubsidized loans are slightly less affordable.

But they are still way better than private loans! They have the same interest rates as the federal subsidized loans, but interest DOES accrue (get added) while you’re in college. This means that every month (while you’re studying) that you don’t pay interest, that interest gets added to your loan balance. Then the next month, interest will get calculated based on your new (higher) loan balance. Note that if you accept this type of loan, you’ll have the option to make interest-only payments while in college. This way, your original borrowed amount will still be the same when you graduate. If you choose not to make any payments while in college, your borrowed amount will be much higher. 

PLUS loans are the least affordable type of federal loan–and (if you’re an undergrad) are actually given to your parents.

PLUS loans have a higher interest rate than the Direct loans, and interest accrues while you are studying. Their rates may or may not be better than private loans, so compare your options! Also, if you are an undergraduate and your parent is unwilling to take on debt for you (or doesn’t qualify because they have “adverse credit”), then this option might not actually work. 

Summary of Terms

Direct Subsidized LoanDirect Unsubsidized LoanPLUS Loan
EligibilityBased on financial need; Undergraduates onlyCan qualify regardless of financial need;Undergraduate and graduate studentsCan qualify regardless of financial need;For parents of undergraduates, or directly to graduate students
Interest rate (for 2020-2021 academic year)4.53%4.53%7.08%
Origination fee1.059%1.059%4.236%
Interest accrues while studying?NoYesYes
Max borrowing amountFor dependent students: $3500 (first year), $4500 (second year), $5500 (third year and beyond)Maximum is set for total between subsidized and unsubsidized: $5500 (first year), $6500 (second year), $7500 (third year and beyond)The maximum is the cost of attendance at the school, minus any other financial assistance received.

How do I qualify for these loans?

For all federal student loans, you need to complete the FAFSA. Based on this information, your college will provide you with a financial aid award letter, which details how much you’ve been offered in grants and federal loans. You can only borrow up to the amount offered to you in your award letter. (However, if you feel you did not receive enough, you could appeal for more aid.)

Two more notes on specific loans:

  • The most affordable type of loan (Direct Subsidized) is only given to students with demonstrated financial need. The school, however, can choose whether (and how much) to offer you with the other two types of loans. 
  • Parent PLUS loan for undergraduates (or Grad PLUS, for graduate/professional students) requires that the parent (or graduate student) pass a credit check. If your parent has bad credit, your family might not be eligible for this loan. 

Finally, before you receive your loan funds, you’ll also need to complete the federal government’s entrance counseling, which helps you understand your obligations to repay the loan. 

What if my award letter is vague–and just says “Direct Loans” or “Stafford loans”? 

Oh man, we could rant for a while about why we think college award letters are awful. We have seen many instances where a college doesn’t specify if the loan is subsidized or unsubsidized. In this case, we recommend you simply reach out to the financial aid office to clarify what you’ve been offered.

What are the current federal student loan interest rates?

The 2020-2021 student loan rate for all Direct Stafford Loans (subsidized or unsubsidized) is 4.53%. It also carries a one-time origination fee of 1.059%. The student loan rate for PLUS loans is 7.08%, with a 4.236% origination fee. 

For more information on how student loan fees work, check out this guide to understanding student loans

Also remember that federal student loan interest rates get re-adjusted every year, so next year’s rate could be higher or lower than this one’s. Just to give you an idea of how much it might fluctuate, here are the rates for the last five years, for undergraduate Direct Stafford loans: 

  • 2019-2020: 4.45%
  • 2018-2019: 5.05%
  • 2017-2018: 4.45%
  • 2016-2017: 3.76%
  • 2015-2016: 4.29%

How much can I borrow in federal student loans?

Here’s what it is for dependent undergraduates (this means you haven’t qualified as an “independent” on the FAFSA):

Subsidized onlyTotal of all subsidized & unsubsidized loansParent PLUS
First year(Freshmen)$3500$5500Total cost of attendance minus financial assistance already offered
Second year(Sophomores)$4500$6500(As above)
Third year & beyond(Juniors, Seniors, and Fifth-Years)$5500$7500(As above)
TOTAL (across all years you’re in college)$23,000$31,000(As above)

However, remember that you can only borrow up to the amount actually offered to you by your college, in your financial aid award letter. If you need more than that, you’ll need to consider taking a private loan, from a company like Earnest

When do I begin repaying?

For Direct Loans (subsidized and unsubsidized), once you graduate, drop below half-time enrollment, or leave school, you’ll begin your “grace period.” This is six months of free time for you to find a job and get financially adjusted, before you’ll need to start making your monthly payments. However, interest DOES accrue (even on subsidized loans!) during this period. 

For unsubsidized loans, you will have the option to begin making interest-only payments while in college. This will prevent your interest from accruing and “capitalizing”–meaning that you’ll then need to pay interest on your interest. However, if you don’t think you’ll be earning enough during college, you can choose to defer all payments until after the grace period. You’ll just need to repay more money overall. (For more information on capitalization, check out our full How Student Loans Work explainer here.)

For PLUS loans, you are required to make monthly payments immediately after disbursement (i.e., after you get the money). There is no grace period. However, as a parent borrower, you can request a six-month deferment after your child leaves or completes school. 

How long do I have to repay my loans?

Under the standard and graduated loan payment plans, you have 10 years to repay. However, since a shorter repayment term means higher monthly payments, if you find that these payments are unmanageable, you have a few options: 

  • Refinance your loans into “Direct Consolidated Loans” – which will extend your repayment plan to up to 30 years. 
  • Switch to income-based repayment. You can choose between a few different plans, but they will all extend your repayment term to 20-25 years. 

What are the repayment plan options for federal student loans? 

There are two types of repayment options, both for ten years:: 

  1. Standard
  2. Graduated

Standard federal loan repayment means you will pay the same fixed amount for ten years. Your payments will begin once your grace period is over. 

Graduated federal loan repayment means your initial payments start out low and then increase every two years. Your final payment will be at maximum three times the value of your first payment. (So, for instance, your first payment might be for $50 and then your final payment could be for up to $150.)

In addition, if you find that your monthly payments are too high, you can apply to switch to one of these two plans with longer repayment periods: 

  1. Income-based Plan
  2. Direct Consolidated Loan

With income-based payment, your monthly payment will be a percentage of your earnings. There are a few plan options, with your monthly payment being 10-20% of discretionary income for 20-25 years. This means that if you’re not earning anything (or earning below a certain amount), your monthly payment could be $0. So it’s a good choice if you have unstable income, or very low income, as it makes your individual monthly payments more manageable. However, the disadvantage is that the loan term is much longer (20-25 years), so your overall amount repaid might be higher just because you’re repaying for more time. 

With a Direct Consolidated Loan, you can combine multiple federal student loans into one loan, so that you only need to make one payment each month. Based on your total amount (across all loans, now consolidated into one), your repayment period might also be extended: 

  • For loan value up to $7,500:  Still 10 years
  • $7,500 – $10,000: 12 years
  • $10,000 – $20,000: 15 years
  • $20,000 – $40,000: 20 years
  • $40,000 – $60,000: 25 years
  • $60,000 or more: 30 years

However, remember that if you can afford to pay more than your monthly payment, you should. This way, you’ll pay off your loans faster, which means you pay less overall. Otherwise, you’re just paying that annual interest rate for more years! This is why longer repayment periods are a double-edged sword. (For more information on why prepayment is good, check out our essential guide to how student loans work.)

If you want help calculating your total student loan debt and your monthly payments, we can help you do that via our free Insights product.

What about student loan forgiveness?

There are a number of reasons why you might not need to continue payments on your student loans–in other words, have them forgiven, cancelled, or discharged. The three most common reasons are: 

  1. Public Service Loan Forgiveness (PSLF): You can have the rest of your Direct loans forgiven, if you work for the government or a non-profit organization for 10 years and make monthly loan payments during that time. After this point, you can apply for forgiveness, and your remaining balance (what’s left that you still owe) will be voided, so you don’t have to pay it back. Note that PSLF does not forgive any PLUS loans for you or your parents.
  2. Teacher Loan Forgiveness (TFL): If you teach full-time for five complete, consecutive years at a low-income school or educational service agency, you can have $17,500 of your Direct loans forgiven. 
  3. Closed School Discharge: If your school closes while you’re enrolled or soon after you withdraw, you can have all your Direct loans discharged (which means you don’t have to pay any of it back). 

There are other reasons related to death, disability, bankruptcy, or improper college management. You can find the full list here. In all cases, you’ll need to fill out an application to request your loan be forgiven, cancelled, or discharged.

By signing up for Going Merry, you’ll gain access to lots of free college financial aid tools, including a college budget, cost analysis, and debt calculator. Sign up today!

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