How Do Student Loans Work? Your Guide To Making Good Decisions

I’ve helped students and new grads manage over $2 billion in student loans.  I’ve been to over 100 universities to discuss student loans. 

Recently, I was at the University of Michigan speaking to a graduate program and I asked at the beginning of our class, “What is the most important item you want to learn about when it comes to student loans?”

One individual slowly raised her hand and said, “I have no idea where to begin.  How do student loans work?”

The amazing part, this individual was 25 years old, already had over six figures in student loan debt, and no idea how they even work! This is not acceptable.

Therefore, on my flight back I wrote this article because no one should enter college without knowing how student loans work. 

Below, I will discuss how student loans work for all three phases of your academic career:

• Before you begin studying.
• While you are enrolled
• Post graduation

One Major Announcement Before Continuing

It amazes me how many scholarships and grants go unclaimed every year.  Before ever getting a student loan, be sure to exhaust all alternatives first.  

Plus, you should look to minimize student loans by other means such as working part-time, buying old versions of text books, etc…

How Student Loans Work Before You Begin Studying

There are a few steps you need to take before classes begin to make sure you’re ready.

First thing you’ll want to do is fill out your FAFSA form. FAFSA is the form that determines your eligibility to receive loans.

You’ll be notified a few weeks after completing the FAFSA with details on how much federal student loans you’re eligible for.

You will need to contact your school to find out when you’ll receive financial aid because each school is different and on different schedules (semesters vs quarters, start dates, etc.).

Once loan disbursement happens, a portion will automatically be sent to your school for tuition. If there’s any remaining amount, you will receive a check.

For example, let’s assume you qualify and confirm you want $10,000 and tuition is $6,000.  Then $6,000 will be sent to your school and $4,000 to your bank account.  You can then use the student loan money on various items you need throughout the school period.

Federal Student Loans Vs Private Student Loans

Due to the way Federal loans work, you’ll always want to get them first.  They are cheaper and you have greater repayment options.

However, you can only borrow so much in Federal loans.  Therefore, if you still need money, you’ll have to get private student loans.

How Much In Federal Student Loans Can I Borrow?

How student loans work in regards to how much you can borrow is complex.  However, I will provide a high level synopsis below.

Each school certifies an amount they believe you need each school period for tuition, books, and cost of living.  Therefore, the amount you can take depends on the university you are attending.

However, there are aggregate limits for subsidized and unsubsidized Federal loans (I detail the difference between these two loans in the next section).

The max Federal loans you can take for undergraduate studies is $57,500. Of that amount, the max in subsidized loans is $23,000.  This is also broken down into annual limits.

In addition, this amount will very based on being a dependent student or independent student.  Basically, if your parents claim you on their tax return, you’ll be eligible for less.

Do You Take Out Student Loans Per Semester?

If you are taking out Federal loans, you complete FAFSA once per year.

Then your loans are disbursed based on your academic year.  Therefore, to figure out how student loan disbursement works, you’ll have to ask your financial aid department.  You’ll definitely want to do this so you can plan accordingly.

Private student loans traditionally require you to apply every time you want a loan. However, some companies are now allowing you to apply once and have multi-year approval.  Therefore, you apply once and you can always get additional funding without having to apply again.

How Do Fees Work On Student Loans?

Yes, the Federal government charges you fees to take out loans.

For subsidized and unsubsidized loans, the fee is 1.057% of the loan balance.

For PLUS Loans (These are for grad school) the fee is 4.228% of the loan balance.

Most private lenders do not charge fees.

What Are Current Student Loan Interest Rates

Rates are reset July 1st every year for Federal student loans.  The current interest rates are:

Direct Subsidized and Unsubsidized loans for undergraduates: 5.5%

Direct Unsubsidized for graduate or professional students: 7.05%

Direct PLUS loans for parents, graduate, and professional students: 8.05%

Private student loans vary but we are typically seeing rates between 9% and 11%.

How Student Loans Work While In School

How student loans work in school is a lot less complex than getting them or repaying them.

When you’re in school, your federal student loans will be put in deferment if you are a full-time student. Being in deferment will put your student loan payments on pause until you graduate.

However, deferment means two different things based on if your Federal loans are subsidized or unsubsidized student .

Subsidized vs unsubsidized

You are not required to make payments while you are in school.  However, you are still charged interest on your loans.

For subsidized loans, the government forgives or “pays” the interest while you are a full time student. Therefore, your loan balance won’t increase.

This is not the case for unsubsidized loans.  Therefore, while in school your loan balance increases and the interest charged is based on how much you borrow.

Should I Make Payments While In School?

When borrows hear their loan balance is going to go up, often times they want to start making payments.

However, you may not want to do that if you plan on doing an Income Driven Repayment plan after you graduate do to the way those plans work.  Specifically, on those plans you are going for forgiveness. Therefore, making payments in school makes no since.

This topic is one of the biggest reasons why we recommend building a student financial plan.  Doing so allows you to determine which repayment strategy you may follow so you can make the right decisions while you are in school.

How Do Private Student Loans Work While I’m In School?

It will depend on where you get the loan and the type of private loan that you get.

Therefore, be sure to know the terms of your private loan before signing off on it.

Also, if you don’t have to make payments while you are in school, then all private lenders will charge interest on your loans and 100% of it will be added to your loan balance.

What GPA Does FAFSA Require?

One big item to note. If your GPA falls below 2.0, you no longer qualify for FAFSA.  Therefore, you’d have to get private student loans.

How Student Loans Work After You Graduate?

Once you graduate, you will have a six month grace period before you have to make a payment on your Federal student loans.

You only get one six month grace period.  Therefore, if you graduated from undergrad school and took a year off then went to grad school you will not get an additional six month grace period on your undergrad loans.

For private loans, you may or may not receive a grace period. Again, each company is different so be sure to read the docs before signing.

How Federal Student Loan Repayment Works

Once your grace period is up on your Federal loans, you’ll need to pick a repayment plan.

There are nine different repayment options you can pick between.

To make it easy, at FitBUX we break these nine different plans into 2 different strategies.  The payoff strategy or loan forgiveness strategy.

The payoff strategies are essentially how you’d typically think about paying off a loan.  The goal is to pay them off ASAP.

However, there are loopholes you can take advantage and you’ll also want to look into student loan refinancing.

Repayment plans for pay off strategies are the standard and graduated plan. Some also take advantage of the IDR Plan SAVE to pay off their loans.

The loan forgiveness strategies, also called income driven repayment plans, are the exact opposite of how the payoff strategies work.

You’re essentially trying to pay as little as you can and aggressively save money.

There are a lot more variables with loan forgiveness strategies such as your income, marriage status, loan amount, and future income.

Not only do you have all these variables but you also have to worry about a big tax bomb at the end of these loan forgiveness plans.

This is going to be crucial because sometimes that tax is a large number.

Income driven repayment plans include SAVE, PAYE, IBR, and ICR.

Student Loans For Grad School

Understanding how student loans work for graduate school is extremely important because of absurd cost of attendance now days.

Before getting into how they work, I want to give you a historical perspective because it highlights how important this topic is.

In the past, a financial expert like myself would geek out and run analytics to determine what cost relative to income would make graduate school worth it.

In short, if you graduated with a 1:1 ratio of student loan debt to income, it was worth it.  This means, if your expected income post graduate school was $75,000 and you could graduate with $75,000 or less in student loans, it was worth it.

Times have definitely changed.  Now days, its common for Member’s of FitBUX to finish grad school with a 2:1 or 3:1 ratio. For example, they expect to make $70k in income but have $210k in student loan debt.

To make things even more difficult, we now have repayment options such as income-driven repayment plans.  There are also forgiveness features such as public service loan forgiveness.

All these factors combined (cost, repayment options, forgiveness) make financial planning extremely difficult.

However, understanding how student loans work for graduate school will help you simplify everything.

What is a graduate student loan?

First and foremost, there are two somewhat obvious points to make about graduate student loans but I must state them:

• You can’t use them for undergraduate studies, trade schools, or professional schools; and
• You have to pay them back!

There are two student loan options for graduate school:

• Federal student loans; and
• Private student loans.

Keys To Know

• You can take out up to $20,500 in Direct Unsubsidized loans per year;
• In total, you may not exceed more than $138,500 in Direct Unsubsidized loans as a graduate student;
• The aggregate limit for Direct Unsubsidized loans includes your undergraduate student loans.
• If you need more than what the Direct Unsubsidized loans provide you, then you can use Direct PLUS loans to fund the rest of your graduate school;
• Loans typically have a 6 months grace period, i.e. you don’t have to make a payment until 6 months after graduate school ends;
• Interest rates are set by Congress every May/June for the following year. The year runs from July 1 through June 30^th;
• You need to be enrolled at least half-time to be eligible for loans;
• Repayment options:
  1. Standard repayment options;
  2. Graduated repayment which no one uses anymore; and
  3. Income-driven repayment/loan forgiveness options.

Private Student Loan Keys To Know

• Most of the time they have a 6 month grace period but not always so you have to check;
• 99% of the time they have a higher rate than Federal student loans;
• There are no income-driven or loan forgiveness options; and
• You choose a repayment term with the most common lengths being:
  1. 5 year term
  2. 10 year term
  3. 15 year term
  4. 20 year term

Does Credit Score Factor Into It?

Yes and no…

Both Federal Direct PLUS loans and private student loans require a credit check. However, they aren’t treated the same.

Federal Direct PLUS loans for graduate school require a check but its not a major factor.  In fact, in seven years, we at FitBUX have not ran into anyone trying to go to graduate school and got denied for Federal Direct PLUS loans because of their credit score.

However, its not the same for private student loans.  They are so strict that most people will need a co-signor to get the loan.  Less than 1% of FitBUX members have gotten private student loans without a co-signor!

Do I need private student loans for graduate school?

The government now funds 100% of graduate school with Federal loans.  This includes tuition, cost of living, etc…

Therefore, its’ very seldom that you will use private loans for graduate school and you want to avoid them if possible.  They are more costly and they have less repayment options.

However, some people may use them because the 100% funding isn’t always 100%.

If you do need them we recommend the following companies:

Your Schools Certified Amount

The Federal government says they fund 100% of graduate school but that isn’t 100% accurate.

Each year every university must certify an amount with the government.  This certification is the universities estimate of total cost which includes tuition and cost of living.

The universities do not want people to drop out.  Therefore, they are extremely conservative on these estimates, i.e. they put in a very large cushion for cost of living.

Thus, you should be able to get 100% of graduate school funding by the Federal government.

How do you apply for graduate student loans?

To be eligible for Direct Unsubsidized Federal student loans, you need to complete the Free Application for Federal Student Aid (FAFSA)

If you took out Federal student loans for undergrad, this process should be familiar to you.

The only difference is for undergrad you most likely filed as a dependent.  For graduate school, you’ll file as an independent student.  Therefore, you don’t need to provide any parental information.

Next comes one of my biggest pet peeves.  Once you submit your FAFSA, you are given your financial aid award letter from your college.  ITS’ NOT AN AWARD! IT’S A FREAKING LOAN!

Sorry, short rant is over.  This “award” letter will detail the Federal student loans you’ve been offered.

Your “award” may not be enough to cover your cost.  Therefore, you will need a Grad PLUS loan.  You will apply for this after completing the FAFSA.  Each university is different so contact your financial aid office for their requirements.

How do private student loans work for graduate school?

Private student loans are offered by banks, credit unions and online lenders.

Some private student loans must be paid back while you’re in school. However, most online lenders now offer you the ability to defer while you are in graduate school.  Others may require a small monthly payment such as $25.

Also, fixed rates are possible with private loans. However, most of the time we see students get variable rate loans. Therefore, be careful what you choose!

Conclusion

For some reason, how student loans work is an extremely confusing topic.  To be clear, the Federal government has made it extremely confusing when it doesn’t need to be.

This article was created to guide you through the major topics you need to know in regards to how student loans work.

However, we know it can be confusing.  In addition, after you read something you may still have a hard time figuring out how to apply it to yourself.

Therefore, FitBUX is here to help navigate these uncharted waters with you.

We have developed a financial planning technology and service designed specifically for student and new grads, aged 20 – 40.  We can help you plan while you are in school and for those that already graduated we can help you as well.

Become a member by signing up at Fitbux.com.  We’re looking forward to helping you.

By David Hughes and Joseph Reinke, CFA