Paying back student loans is a substantial financial obligation. As of 2020, roughly 44.7 million Americans borrowed money to pay for school. Collectively they owe nearly $1.6 trillion in student loan debt, with an average obligation of $32,731. As with all sources of debt, it is vital to understand how to effectively manage student loans before and after graduating. Before you begin to consider a loan strategy, read below to get a better understanding of the types of loans and the differences between them.
Terminology to Know
FAFSA – The Free Application for Federal Student Aid, is a government form that borrowing students and their guardians must complete to qualify for government-provided benefits such as state grants, federal student loans, and work-study funds.
Principal and Interest Rate – The elements to consider when taking out a student loan are the primary, or principal, and the interest. The primary is the amount you borrow and need to pay back, and the interest is what the lender is charging you for the loan and is calculated as a percent of the primary. On a federal student loan, the interest rate is set by Congress through legislation. Conversely, on a private loan, the interest rate is set by your lender and can be affected by a variety of factors including, your credit rating, whether or not you have a cosigner, and the type and length of your loan. Loans with lower interest rates generally will cost you less over the duration of your repayment plan.
Types of Student Loans
There are two main types of student loans: federal loans and private loans.
Federal Student Loans
Federal student loans are funded by the federal government, and as such, their interest rates are determined by Congress. Federal student loans offer several favorable protections, such as the ability to tie payments to income upon graduation through an income-driven repayment plan or have loans forgiven if you work in a public service field. Federal student loans are easily obtainable: nearly every high school graduate is eligible for some form of federal student loans; a cosigner is not required, and you do not necessarily have to have a good credit score upon applying.
Federal student loans can be further categorized into direct subsidized and direct unsubsidized. There are significant differences between the two.
Direct subsidized loans are available only to undergraduate students who demonstrate financial need. These loans have a low, fixed interest rate but have lower loan amounts available for borrowing. The greatest benefit to direct subsidized federal student loans is that if you qualify for one, the Department of Education pays the interest on your loan. At the same time, you are enrolled in school six months after you graduate (your “grace period”) and during any period of deferment.
Under the Federal Perkins Loan Program, “Perkins loans” are offered to undergraduate and graduate students with high financial need. Perkins loans have a fixed interest rate of 5% and are offered through your college or university who acts as the lender. These funds are typically limited, and not all schools offer these loans. Contact your school’s financial aid office to confirm their availability.
Direct unsubsidized federal loans are available to both undergraduate and graduate students and are more widely available because they are not need-based. They have higher loan limits available for borrowing but carry a higher fixed interest rate than the direct subsidized federal loans. They also do not offer as advantageous repayment benefits as federally subsidized student loans. A student can defer payments on unsubsidized loans until after graduation, but the interest on unsubsidized loans begins accumulating as soon as the loan is taken out. The student can then either pay the interest as it accrues or allow it to accrue and be capitalized – added to their principal balance (total sum of money borrowed plus any interest capitalized) – for repayment after graduation. The interest also accrues during any grace period or deferment. For these reasons, it is best to maximize any federally subsidized loans available to you before turning to unsubsidized loans.
Federal Direct PLUS loans are available to graduate students and parents of dependent undergraduate students. Here, the U. S. Department of Education serves as the lender, and payments are often made directly to the school to cover expenses such as tuition and room and board. If there is money remaining after those expenses are paid, the funds will be paid directly to the student. The maximum loan amount is equal to the difference in the cost of attendance and any other financial aid received. PLUS loans require a credit check and typically have higher interest rates and origination fees – fees representing a percentage of your loan amount, charged by your lender for the processing of your loan – than other federal student loans. However, borrowers with an adverse credit history can apply with a cosigner. While repayment obligations on these loans generally begin as soon as the funds are disbursed, you may be able to defer repayment as long as you are enrolled in school at least half-time (registered in half of the expected course load) and for a six-month grace period after that enrollment ends.
Private Student Loans
Typically, banks, schools, and other financial institutions serve as lenders for private student loans. During the application process, lenders will require proof of your ability to repay your prospective loan, usually in the form of a good credit score, or a cosigner who will be liable to repay the loan in your place if you are unable to make payments. Depending on your creditworthiness, you may face variable and/or higher interest rates. Generally, private loans do not include the same favorable protections and financial benefits as federal student loans. For example, during repayment of a private loan, you may face fewer options to defer repayment or decrease your monthly payments. However, while federal student loans may be more suitable for your specific financial situation, private student loans do help borrowers fill the financial gap between what the government will lend to you and your total cost of attendance. Private student loans are available for a variety of circumstances, including bar exam loans, medical school loans, international student loans (non-U.S. citizens are typically unable to qualify for federal student loans), and for those students with bad credit or no cosigner.
You have worked hard on your educational journey, and planning a proper loan strategy can help you achieve your future educational goals. Talk to your financial advisors to strategize the best options for you today!
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