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How Do Student Loans Work?

How Do Student Loans Work

12 MINUTE READ

“Student loans—my favorite!” (Said no one ever.)

Here’s the thing about student loans: Not enough students understand how they really work or the effect they can have on future goals and plans. When you’re about to graduate from high school, it can feel like everyone wants you to continue your education, but nobody can tell you the best way to pay for it. It’s just kind of expected that if you want to go to college, you’re going to have to take out a massive loan (or two) in order to afford that diploma.

And that’s why we have a $1.6 trillion student loan crisis in our country right now.1  Listen: I get it. When I was in high school, no one warned me about the dangers of loans or told me how to prep for college the right way, and I made a lot of dumb decisions as a result. But I’m here to make sure that won’t happen to you!

In fact, I’ll make a deal with you. I’ll tell you everything you need to know about student loans if you promise not to take them out. Deal? Deal. (I’m so serious.)

What Is a Student Loan?

A student loan is money borrowed from the government or a private lender in order to pay for college.

 

Going to college debt-free is possible! Find out how.

The loan has to be paid back later, along with interest that builds up over time. The money can usually be used for tuition, room and board, books, or other fees. But some students use their loan money for other stuff—like trips to Jamaica for spring break.

Let’s be clear: Student loans are different from scholarships and grants. Loans always have to be paid back (unless you’re one of the lucky few who gets part of your loan forgiven, but that’s pretty rare). Scholarships and grants, on the other hand, don’t need to be paid back (everyone loves free money, right?). Student loans are also different from work-study programs, where students get paid to work on campus.

How Do Student Loans Work?

People get federal student loans by filling out the Free Application for Federal Student Aid (FAFSA). Students and their parents share their financial information on the form, which is then sent to the student’s schools of choice. The financial aid office at each school crunches some numbers to figure out how much (if any) aid the student qualifies for, and then sends them an “award letter” with all the details about their financial aid offer.

Note: This aid could come in the form of student loans, or it could come in the form of scholarships and grants. So that’s why I still recommend filling out the FAFSA—just make sure you only accept the free money. This is a no-loan zone, people.

Students apply for private student loans straight from the lender. But no matter if the loan is federal or private, the student has to sign a promissory note (sounds scary, right?). That’s a legal document where the student agrees to repay the loan plus interest, and includes all the terms and conditions of the loan.2 It’s kind of like signing away your freedom. Kidding, but not really.

Types of Student Loans

There are two main types of student loans: federal and private. They’re both poisonous for your future, but the main difference is that federal loans are issued by the government, while private loans can be issued through a bunch of different sources, like banks, schools, credit unions or state agencies.

Federal Student Loans

• Direct Subsidized Loan: These are undergraduate loans for students who show financial need based on their FAFSA. The government pays the interest until the time comes to start paying the loans back. Once the student leaves school or drops below a certain number of hours, there’s a six-month grace period before repayment starts and interest begins to build up.

• Direct Unsubsidized Loan: These are undergraduate or graduate loans where students do not have to demonstrate financial need. With unsubsidized loans, the government doesn’t cover the interest—interest starts building up from the minute the school gets the loan money.

• Direct PLUS Loans: These are loans that parents can take out for their dependent students or that graduate students can take out for themselves. These require a separate application from the FAFSA and a credit check.

Private Student Loans

Basically, all you need to know about private student loans is that they’re usually more expensive and have higher interest rates than federal loans, and the student has to start making monthly payments while they’re still in school. It’s up to the lender to decide all of the terms and conditions of the loan. Plus, the student is responsible for all interest payments—there’s no counting on the government for help.

How Does Student Loan Interest Work?

Man, I love interest. The good kind of interest that makes your investments grow from a couple of hundred dollar bills to a mountain of cash, that is. But what about when it’s loan interest? That’s a totally different story. The way interest works on a loan means you end up paying way more money than you originally borrowed. It’s the worst.

To figure out your loan interest, you have to understand a few terms. Boring, I know. But stay with me!

Loan Repayment Term: That’s how long you have to pay the loan back. For most federal loans, that’ll be 10 years (but it can take up to 30 years).3 For private loans, the term can vary based on the terms of your loan agreement.

Interest Rate: This is how much interest you’ll be paying on the loan. Federal loan rate percentages can vary per loan, but they’re usually fixed (meaning the interest stays the same every year). Private loans are typically based on your credit rating, so they can vary a lot—and they can be fixed or variable.

Principal: This is the base amount you owe for the loan, not including interest. So if you took out $35,000 in loans, your principal would be $35,000. (That’s the average amount of debt each student loan borrower will graduate with, by the way!4)

So, here’s the math (everyone’s favorite part): Let’s take that $35,000 principal and say you have a 10-year loan repayment term with a fixed interest rate of 5%. (Typical interest rates can range from 4.53–7.08%, depending on the loan type.5) With those numbers, your monthly student loan payment would be just over $370, and the total amount of interest you’d pay during the loan term would be almost $9,550. So, you might’ve started out by borrowing $35,000, but in the end you’d really pay about $44,550.

Are y’all feeling sick yet? I am.

Student Loan Repayment Options

If you decide to take out student loans (which I already know you won’t do, because you promised), you also make a decision for your future self—the decision to spend the next 10 or more years of your life making monthly payments. Don’t be a jerk to your future self.

Here’s a quick look at what you could be dealing with.

Repaying Federal Loans

• Standard Repayment Plans: The government or your lender provides a schedule with a set monthly payment amount. For federal loans, the plan is for 10 years. Private loans will vary.

• Graduated Repayment Plans: The payments start off lower, but they increase every couple of years or so. The plan is still to have everything paid off in 10 years.

• Extended Repayment Plans: These plans extend the payments beyond the normal 10-year window for borrowers who have more than $30,000 in outstanding loans. The payments could be fixed or graduated (meaning the payments increase little by little) and are designed to pay off the loan in 25 years.

• Income-Based Repayment Plans: These plans base your payments on a percentage of your income. Usually, you’ll pay between 10–15% of your income after taxes and personal expenses are covered. The payments are recalculated every year and adjusted for things like the size of your family and your current earnings.

• Income-Contingent Repayment Plans: This is similar to the income-based plan, but is based on 20% of your discretionary income (that’s the amount of income you have left after your set expenses are taken care of). The rates are adjusted every year and the balance can be forgiven—and taxed—over time (usually 25 years).

• Income-Sensitive Repayment Plans: These are similar to the other income-related plans, but the payment is based on your total income before taxes and other expenses, instead of your discretionary income. The loan payment is calculated to be paid off in 15 years.

Repaying Private Loans

Since private loans are agreements between you and the lending institution, the lender makes the rules for payment. You’ll pay a set amount each month that’s a combo of a principal payment and interest, and the payments are usually set for a specific amount of time. Any changes in that plan—like a graduated payment schedule—would need to be negotiated with the lender (you could always try bribing them with cookies or something). 

What happens if you can’t afford your monthly payment?

Now listen, you guys: When you take out student loans, you commit to paying back the money. You might’ve heard about some of these options before as being an “easy way out.” But honestly, these options are only temporary, short-term fixes to long-term problems—and sometimes, they can end up costing you more in the long run.

  • Forbearance: Your payment is put on hold, but the loan continues to accumulate interest. There are two types of forbearance: general (where the lender decides your level of need) and mandatory (where the lender has to grant forbearance based on your situation).
  • Deferment: With deferment, you temporarily don’t have to make payments, and you may not be responsible for paying interest on your loan. Not everyone is eligible for deferment or forbearance, but you might qualify if you’re unemployed, serving in the military during wartime, or serving in the Peace Corps.
  • Student Loan Forgiveness: Again, not everyone qualifies for this—there are a whole bunch of different requirements, like working full time in a qualifying public service job while making payments for 10 years, teaching in a low-income school for at least 5 years, etc. The scary thing is, as of June 2019, only 1.09% of applications for student loan forgiveness through public service were actually approved.6 You can’t rely on this stuff, y’all.
  • Default: This is what happens if you keep missing payments. Your loan is referred to as delinquent the day after you miss one payment, and if you continue to miss payments, you go into default. This means you failed to pay back the loan based on what you agreed to when you signed the paperwork, and it can have super serious consequences. You could be taken to court, lose the chance to get other financial aid, or be required to pay the entire balance of your loan right away. Not fun.

How to Avoid Student Loans

Still not convinced that student loans are the worst way to fund your education? What if I told you that roughly one in five students owes more than $100,000 in student loans (which seriously slows down all financial progress after graduation)?7 According to our own Ramsey Research, 63% of student loan borrowers worry consistently about paying back the money, and 44% of them say they can’t even buy a house because of their student loan debt.

You might be thinking: Okay, Anthony, I get it. Student loans are bad. What’s the alternative?

I like the way you think. And even though the rest of the world makes it seem impossible, you can cash flow your whole college experience with some smart strategies and hard work.

Here are just a few examples of how you go to school without loans:

  1. Find scholarships and grants. You can find free money by filling out the FAFSA form,  researching organizations in your field of interest that offer scholarships, and using an online search tool like this Debt-Free Degree Scholarship Search.
  1. Choose a school you can afford. That might mean starting out at community college or going to a public, in-state school instead of a private university (there really is a huge difference in tuition costs). It might mean going to a trade school or directional school—and that’s totally okay. If you find yourself asking if college is really worth it, remember: The only real “dream school” is the one you can afford to go to debt-free.
  1. Work. Yep, even when you’re in high school. A part-time job or side hustle won’t hurt your grades if you keep it to 20 hours per week or less, and you’ll make bank for your college fund. Once you’re in college, try looking for an on-campus job or work-study program, or apply to be a teaching assistant.
  1. Be smart about your lifestyle. Going to college doesn’t mean you have to live in a designer dorm room with a $10,000 meal plan. Live at home if you can. Stop eating out with your friends every weekend. Split groceries, rent, and utilities with a roommate (or three). Use public transportation or walk whenever possible. Get creative and find other ways to cut down on costs. And listen up, y’all: Stick. To. A. Budget. That will make all the difference in helping you take control of your money.

 

I say it all the time: The caliber of your future will be determined by the choices you make today. When you take these steps now, you set yourself up for a lifetime of success (and freedom from those monthly payments). Now let’s make it happen!

 

 

How Do Student Loans Work? Anthony ONeal - https://www.daveramsey.com/blog/how-do-student-loans-work

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