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 Sallie Mae, Earnest, or Discover.

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 for July 2022 – June 2023:

• Interest rate: 4.99% 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: $5,264.96
• Interest paid over 10 years: $1,764.96 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, private student loan company 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. 

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, let’s say a Federal Direct Subsidized Stafford Loan has a fixed rate of 4.99%. Every year for the entirety of your loan term (usually, 10 years), you will pay this 4.99%. 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.

In May 2023, the Credible loan marketplace found that, for someone with a credit score of 720, the average 10-year student fixed-rate loan (with immediate repayment) was 8.23%, up significantly from about 6.04% about a year earlier.

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; and psst you’ll get an extra discount for using that link!)

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 (meaning instead of $10 interest, it’s now $10.10).

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?

Like with all big purchases, you should definitely shop around before deciding on which company to use for your student loan. You can request quotes (like this one) from multiple student lenders, and then compare things like:

• Interest rate
• Fees (e.g. origination fee, administration fee) and penalties (e.g. late fees, early repayment penalty)
• Flexibility (e.g. can you pause payments if you loose your job?)
• In-college payment plan (e.g. can you pay nothing, or only a small monthly amount, while you’re in college studying?

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. Shop around! Make sure you’re getting quotes from multiple companies and comparing prices. A small difference in interest rate can make a big difference in final cost. (Here’s one place to get started.)
4. 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!
5. 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! 

Disclaimer: Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

Before applying for private student loans, it’s best to maximize your other sources of financial aid first.  It’s recommended to use a 3-step approach to assembling the funds you need: 1) Look for funds you don’t have to pay back, like scholarships, grant, and work-study opportunities.  2) Next, fill out a FAFSA(R) form to apply for federal student loans.  Federal Direct subsidized and unsubsidized loans, excluding PLUS Loan for Parents and PLUS Loan for Graduate and Professional Students which require a credit check and a credit worthy endorser if the parent or graduate or professional student has adverse credit, do not require a credit check or cosigner, and offer various protections if your struggling with your payments.  3) Finally, consider a private student loan to cover any difference between your total cost of attendance and the amount not covered in steps 1 and 2.  For more information, visit the Department of Education website at https://studentaid.ed.gov.

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Charlotte Lau

Charlotte remembers the anxiety of college application time, trying to get into a good university and then finding enough funds to pay for it. She joined Going Merry as Head of Growth, to help make that college process a little less stressful. Charlotte holds a BA from Stanford and a MPP from Oxford—degrees both funded by scholarships. For several years, she also tutored academic writing and edited college/fellowship applications, as a side hustle.

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