How Do Student Loans Work? This Is Your Complete Guide
Unsurprisingly, it's one of the top questions asked by college-bound students: How do student loans work? After all, higher education is expensive. Even with grants, scholarships, and savings, many people must turn to loans in order to help cover the cost of post-secondary training. So it's essential to have a solid grasp of what's involved.
If you're confused about the process, you're not alone. In one survey of people who borrowed money for college, only 15 percent were "very confident" that they understood how student loans work. Many borrowers were unclear about things like when interest accrues and what types of loans are eligible for forgiveness.1 Bottom line, you definitely need to have a full grasp of these kinds of details in order to make better financial choices.
That's where this guide comes in. The information below will help you understand the differences between federal and private loans and how you can qualify and apply for them. You will also discover what student loans cover and what factors you should consider when deciding how much debt to take on. Plus, you will learn how loan repayment works and what to do if you run into problems.
- Federal loans vs. private loans: A summary
- How do federal student loans work?
- How do private student loans work?
- How to take out student loans
- What student loans cover
- Student loan debt: How much is too much?
- How loan repayment works
- What to do if you have repayment problems
- How do student loans affect taxes?
Federal Loans vs. Private Loans: A Summary
As a general rule, the federal government is the best place to get student loans. That's because federal loans are typically easier to get and offer more generous benefits than private loans. For instance, federal loans usually have lower interest rates that remain fixed for the life of the loan. They do not typically require you to have steady income or even decent credit. And since these loans are backed by the government, you can take out a student loan without a cosigner. If you qualify for subsidized loans, the government will even cover your interest payments while you're in school. Federal loans also offer a wide range of flexible options for repayment.
However, most federal loans (other than PLUS loans) come with a cap on the total amount you are allowed to borrow, which may not be enough to cover all of your expenses. Thus, you may need to seek out other sources of funds.
Private loans can help fill any gaps in funding. Financial organizations like credit unions and banks offer student loans that may allow you to borrow 100 percent of your full cost of attendance. If you have good credit, you may even qualify for a lower interest rate than the one being offered for federal loans. Also, the application and approval process for private loans tends to be shorter than for government loans.
But private loans have drawbacks as well. Because they require a good credit history, you will likely need a cosigner in order to secure one. Interest rates on private loans are usually higher than on federal loans. Plus, private loan interest rates are sometimes variable, which means the rate could potentially go up and cost you more money. Also, repayment options are more limited with private loans than with federal loans.
How Do Federal Student Loans Work?
When it comes to federal funds, you qualify for student loans if you attend a Title IV school and are enrolled at least half-time in a program that awards a degree or certificate. However, that doesn't mean you qualify for every kind of federal loan.
Student loan options are more limited than they used to be after Perkins loans were discontinued in 2017, but three main types are still available. These include direct subsidized and unsubsidized loans (also known as Stafford loans) as well as PLUS loans. Here's how they work:
Direct subsidized loans
Subsidized loans are available to undergraduate students who exhibit financial need. They're called subsidized because the federal government pays the interest while you attend school, for six months after you graduate, and during any times of deferment (i.e., when your loan payments are temporarily put on hold). Once you leave school and your six-month grace period ends, you must begin repaying the loan, and you will be responsible for the ongoing interest.
All direct loans for undergraduate students that are first paid out between July 2019 and July 2020 have a fixed 4.53-percent interest rate. That rate remains the same for the duration of the loan, which makes your monthly payments easy to predict.
You can receive $3,500 to $5,500 in subsidized loans each academic year, depending on what year of schooling you are in. In total, you can receive no more than $23,000 in subsidized loans.
All federal loans charge an origination fee that gets taken off before you receive any funds. On subsidized loans, the fee is set at 1.059 percent for disbursements (i.e., payouts) made between October 2019 and October 2020. Here's what that means: If you get a subsidized loan for $5,000, you will actually receive $4,947.05, because $52.95 gets deducted for the origination fee. However, you will still have to repay the full $5,000.
Of the available options, a direct subsidized loan is better for students who are eligible to receive one, since the interest savings can be significant. However, you can only use subsidized loans for 150 percent of the length of your program (for example, six years for a four-year bachelor's degree). If you take longer to finish your studies, you won't be able to get another subsidized loan.
Direct unsubsidized loans
These loans are available to undergraduate, graduate, and professional students and are not based on need. Like with subsidized loans, you do not need to make any payments while you are enrolled at least half-time or for six months after you leave school.
However, unlike with subsidized loans, you must pay all the interest, which begins to accrue as soon as the loan is paid out (and continues to accrue while you are in school and during any periods of deferment). You can opt to pay the interest as you go along; otherwise, it will accumulate and be added to your total loan amount when your post-grad grace period expires.
For undergraduate students, the interest rate on unsubsidized loans is the same as for subsidized loans: 4.53 percent for the 2019-2020 award year. However, graduate students pay 6.08-percent interest. You should be aware that these rates still tend to be lower than the rates charged for private loans.
Borrowing limits apply, but they are higher for unsubsidized loans than for subsidized ones. As an undergraduate student, the maximum amount of student loans you can get depends on whether you are considered dependent or independent. Dependent students can borrow $5,500 to $7,500 each year, with a total loan limit of $31,000. Independent students (or dependent students whose parents can't get PLUS loans) are eligible to receive $9,500 to $12,500 in loans per year, or $57,500 in total.
If you're a graduate student, you can get up to $20,500 per year in direct unsubsidized loans. Note that the maximum student loan amount for your lifetime is $138,500, including any loans you got as an undergraduate.
The 150-percent time limit does not apply to unsubsidized loans, so you can continue to get them no matter how long you take to complete your program.
As with subsidized loans, you must pay a 1.059-percent origination fee on your unsubsidized loans.
PLUS loans are open to graduate students as well as parents of dependent undergraduate students who attend a qualifying school at least half-time.
These loans are not based on need, but they do require a credit check. If your credit is not great (for instance, if you went into foreclosure or declared bankruptcy in the past five years), you might still qualify for a PLUS loan if (1) you get an endorser with good credit or if (2) you document the extenuating circumstances that caused you to have an adverse credit history.
The maximum amount of a PLUS loan is calculated by taking the total cost of attendance and subtracting any financial aid that has already been received. So while subsidized and unsubsidized loans have a fixed limit on the amount you can borrow, PLUS loans can be used to cover the entire cost of attending college.
However, PLUS loans come with higher interest rates than other federal loans. For the 2019-2020 award year, the interest rate is 7.08 percent, as opposed to the 4.53 percent charged on subsidized and unsubsidized loans. The origination fee on PLUS loans is also much higher: 4.236 percent, compared to 1.059 percent. Your best move is to maximize your subsidized and unsubsidized loans before considering PLUS loans.
How Do Private Student Loans Work?
A private student loan is one that is issued by any organization other than the government. Banks such as Wells Fargo and Citizens Bank offer student loans, as do companies like Sallie Mae, CommonBond, and College Ave. The amount you can borrow is limited to the total cost of attendance for your school, minus any financial aid you receive.
Each private lender sets its own rates and terms, so be sure to shop around. Many lenders do not charge origination or disbursement fees, and all of them allow you to repay your loan early without penalty. You might also be able to get a reduced interest rate if you have stellar grades or sign up for automatic payments.
Private loans do not depend on financial need, but they do depend on your creditworthiness. That's because there is no pot of taxpayer money for private lenders to draw upon if you are unable to pay back what you owe. Since most college students do not have an established credit history or a reliable source of income, they typically need a cosigner (i.e., someone who takes on equal responsibility for the loan).
That said, it is possible to get private student loans without a cosigner. Here are a few examples of lenders that don't require one:
- FundingU—Loans of up to $10,000 a year are available to residents of certain states who are enrolled full-time in a bachelor's degree program at eligible schools. A cosigner is not required; instead, eligibility is based on your academic record, employment experience, and other factors that show you are on track to achieve your professional goals.
- Sixup—Residents of certain states who are full-time undergraduate students at eligible four-year colleges may be able to get loans of up to $15,000 a year without a cosigner. To qualify, you must first apply for federal student aid and accept all the aid that is offered to you. Your credit history is not a factor as long as your grade point average is 2.5 or better.
- Ascent—Ascent's Independent student loan is open to college juniors and seniors as well as graduate students who attend eligible schools full-time. Factors that weigh on eligibility include your credit score, the school you plan to attend, and your selected major. You don't need a cosigner, but if you don't have one, the amount of your loan may be less than you requested.
Even if you qualify for a private loan independently, having a cosigner with a better credit record can help you get a lower interest rate. If that means securing a rate that is even a quarter of a percentage point lower than what you could get on your own, you could see a big difference over the long term.
With private loans, you often have a choice between a fixed or variable interest rate. While a fixed rate does not change over the life of the loan, a variable rate moves with the market and could go either up or down. (Some lenders put a cap on variable rates, but the cap can still be quite high.) Initially, the variable rate will generally be lower than the fixed rate. But because a variable rate is subject to market fluctuations, it can be difficult to predict what your monthly payments will be. In the private sphere, the average interest rate for student loans is 8.81 percent (variable) or 9.97 percent (fixed).2
Unlike with federal loans, you may be required to make payments on private student loans while you are still in school. Many lenders offer options to postpone payments, so be sure to find out what's available to you. It's important to understand that interest on private loans begins to accrue from the moment the loan is paid out and continues to accumulate even during periods of suspended payments.
Some lenders allow the cosigner to be released from his or her loan obligations after a few years of on-time payments.
How to Take Out Student Loans
Confused about how to get a loan for school? The process is simpler than you might think. Basically, you take out a student loan by submitting an application and being approved as a borrower. The specific steps differ between federal and private loans.
How to get a federal student loan
Many students find themselves wondering: Is it hard to get a student loan? When it comes to most types of federal loans, the answer is no. That's because your credit history is not a factor in your eligibility (except for PLUS loans). A student can take out a loan for college by following these steps:
1. Complete the FAFSA.
The federal student loan process begins with filling out the Free Application for Federal Student Aid, known as the FAFSA. (For parent loans, the child must complete the FAFSA). You need to do this each year that you want to receive aid. You can fill out the FAFSA for free online, or you can submit a paper application. Before you begin, be sure to have all the relevant data on hand, such as your Social Security number and your tax returns. You will probably also need your parents' information.
If you're planning to apply online, it's a good idea to create an FSA ID username and password so that you can sign the FAFSA electronically. You can also use your FSA ID to access the myStudentAid mobile app and check on the status of your application. (Get the app from Google Play or the Apple App Store.)
How long does it take to process a student loan? Depending on whether you apply online or by mail—and whether you include a valid email address—it can take anywhere from three days to three weeks for your FAFSA form to be processed.
2. Review your Student Aid Report.
About seven to 10 days after your FAFSA has been processed, you will receive a Student Aid Report that summarizes the information from your FAFSA. The report lists the schools you've chosen to apply to and states your Expected Family Contribution (EFC).
The EFC is an estimate of the amount you and/or your parents should be able to put toward your college education. It's not the amount you actually have to pay. It's simply an index number that is calculated using a formula that includes factors like your family size, income, and assets. Colleges use your EFC to determine your eligibility for federal financial aid, so it's crucial to make sure the data is accurate.
Look over your Student Aid Report carefully to ensure that the information matches what you put on your FAFSA. If you find errors, correct them either online or by using the form on the back of the report.
3. Review your financial aid award letters.
If you are approved for aid, the schools that accept you will send you a financial aid award letter. Every school uses its own format, but these letters typically detail the cost of attendance (COA) for the school and list the grants, scholarships, and loans you are eligible to receive for offsetting that cost.
The COA represents what it costs, on average, to attend the school for one academic year. It includes not just tuition and fees, but also books, room and board, and miscellaneous personal expenses like transportation home for holiday periods. Schools have different COAs for in-state and out-of-state students, as well as students who live on campus and those who live off campus.
Colleges determine your financial need by taking the COA and subtracting your EFC. The higher the difference between those two figures, the more aid you will be eligible to receive. If your need is high enough, you may qualify for subsidized loans.
It's essential to read the award letter carefully so that you can decipher exactly what is being offered to you. Unfortunately, many schools use different jargon and terminology. In fact, one study found that colleges used 136 different terms to describe a direct unsubsidized loan, and two dozen of those terms did not even use the word "loan."3 So you might see a line item like "Direct Federal Unsubsidized Lo," "Federal Unsub-Direct Stafford," or even just "Direct Unsubsidized L," followed by an amount.
4. Accept the loans you want.
If a school's aid package includes federal loans, the school will explain how to accept the loans. Keep in mind that you do not have to accept all of them. For example, you may decide to turn down a loan if it means borrowing more money than you want to take out. You can always contact your school's financial aid office and ask for a review of your situation.
For parent PLUS loans, most schools will instruct you to request the loan at StudentAid.gov. As part of the application process, you can request a deferment for the period that the student is in school and for six months after he or she graduates. If you don't ask for the deferment, you will have to start repaying the loan within 60 days of getting the final disbursement. Note, however, that interest will still accrue during any deferment period.
If you have not received a federal loan before, you must undergo loan entrance counseling to make sure you understand your repayment obligations. This can be done online and typically takes no more than half an hour. You'll also be required to sign a Master Promissory Note (MPN), which is a contract that sets out your loan terms. Parents who are applying for PLUS loans do not have to go through entrance counseling, but they do have to sign the MPN.
So after all that, when do you get student loan money? Federal loan funds are generally applied to your school tuition and fees no earlier than 10 days before the start of each term. First-time borrowers may have to wait 30 days after the start of the term. Any funds that are left over will be refunded to you.
How to get a private student loan
You should always apply for federal aid before considering private loans. But if you've maxed out your subsidized or unsubsidized federal loans and still need more funds, a private loan may be the way to go. Here's what you need to do:
1. Research your options and apply to each lender.
Once you've shopped around and selected a lender, you can fill out the application online. Each lender has its own requirements, but you typically need to provide:
- Your Social Security number
- Your income and employment details
- The cost of attendance for the school you plan to enroll at (found in your financial aid award letter)
- The requested amount of your loan
- Your cosigner's information
Before you actually submit the application, you will receive a disclosure document that explains the range of interest rates that are applicable, the fees that are involved, and the repayment options that are available. Read the document carefully, but keep in mind that you won't know exactly how much the loan will cost until the bank has a chance to review your application.
2. Wait for approval.
Once your application is complete, the lender will assess your credit history to determine if you are eligible for a loan and how much you will be allowed to borrow. You may be asked to provide additional information or documents. For instance, you will likely have to fill out a Private Education Loan Self-Certification Form to acknowledge that you are aware of the availability of lower cost federal financial aid.
3. Accept the terms.
If you are approved, you must accept the terms of the loan. Some lenders set the terms for you, but others allow you to do things like select a repayment plan and choose a fixed or variable interest rate.
Once the terms have been finalized, you will receive another disclosure document that contains all the specific details regarding interest rates, fees, and repayment for your loan. Review it carefully to ensure that you understand how much you will receive and how much you will have to repay. If the terms are acceptable, sign the loan documents. You can usually do this electronically.
4. Wait for certification.
Your lender will send the loan details to your school so that it can certify, or verify, some key information. For example, the school must certify that you are enrolled there and that the amount of your loan is not greater than the cost of attendance minus any other aid. This normally takes around a week to 10 days, but it can take longer during busy periods.
Once the loan has been certified, you will receive the final disclosure from your lender. At this point, there is a three-day waiting period during which you can choose to cancel the loan. If you don't cancel, the money will be disbursed on a date set by the school.
What Student Loans Cover
Student loans cover a wide range of educational costs, from tuition and fees to books and equipment. When you apply for federal aid, you must agree that you will use the money only for expenses that are part of the cost of attending your chosen school. Depending on your situation, your financial aid administrator may expand the cost of attendance to include things like child care for dependents, loan fees, and expenses related to a disability.
Here are some eligible expenses that you can use student loans to pay for:
- Fees—These can include library, lab, activity, and technology fees.
- Room and board—In addition to dorm accommodations and meals, student loans can pay for housing, utilities, and groceries for off-campus students.
- Books and supplies—Your loan money can pay for things like textbooks, art materials, or a laptop.
- Transportation—A student loan can be used for a transit pass, gas to commute to campus, or even a flight home during a study break.
So you can use student loans to pay bills in some cases. For example, if you live off campus, you can use student loans to pay for rent. Technically, you can't use a student loan to buy a car, but you can use it to fuel up a vehicle you already own that takes you to and from school.
Remember that loan money is first disbursed to your school and applied to your tuition, fees, and room and board (if you live on campus). If there is money left over, it is given back to you in the form of a check or a direct deposit into your bank account.
Under the current system, no one monitors how you spend that money. You don't have to track your receipts and account for every dollar. But if the Department of Education gets word of potential fraud or misuse of funds, it can and does investigate. In 2016, two Colorado residents were sent to prison for defrauding the federal student loan program.
As of November 2019, the Department of Education is in the midst of implementing a pilot program whereby loan recipients at certain schools would receive their refund on a pre-paid no-fee debit card. Such a program would allow federal officials to start collecting detailed data on how students spend their loan money.
Ultimately, of course, squandering your borrowed money on non-school-related expenses like a new car or a spring break vacation could mean you won't have enough funds left for actual necessities. Always remember that you must repay all loan money with interest, so frittering it away on unnecessary expenses will hurt you in the long run.
It's up to you to be a responsible borrower and only take out what you really need. If you end up with a refund, consider returning the money to your lender so that you can reduce the amount you owe on your loan.
Student Loan Debt: How Much is Too Much?
The amount of debt that is acceptable for a college student depends on each person's unique circumstances. After all, even if you can borrow $100,000 in student loans, that doesn't mean you should.
According to data from the class of 2018, a "normal" amount of student loan debt is $28,565. That represents the average amount of debt per borrower among students who completed a bachelor's degree at a four-year college or university.2 Whether $28,565 is too much in student loans depends on a number of factors, including what repayment options are open to you and how much you can expect to earn in your future career.
As a general guideline, the amount you borrow should not exceed your starting salary after you graduate. For example, if you are preparing to become a registered nurse, you can expect to earn roughly $50,800 a year at the beginning of your career.4 So as a maximum, you should take out $50,000 in student loans.
However, your goal should always be to borrow as little as possible. That's because every dollar you borrow must be paid back with interest.
Before borrowing any money for your education, be sure to seek out and apply for grants and scholarships. They offer free money that does not have to be repaid, and they can help reduce your total debt load. Getting a loan is what to do when you run out of financial aid.
How Loan Repayment Works
All student loans are borrowed money that must be paid back with interest. When and how you do that will depend on what type of loan you have.
Most federal loans do not require you to make any payments until six months after you leave school. Some private lenders will also allow you to put off payments while you are enrolled, so be sure to check.
Even if you don't have to make payments while you're in school, interest does accrue during that time. If you have a subsidized loan, the government pays the interest for you until your grace period ends. If you have an unsubsidized, PLUS, or private loan, you must pay that interest, so it gets added to your loan balance.
The amount you pay on student loans per month is driven by the amount you took out, the interest rate you received, and the length of your repayment period. The average monthly student loan payment is $393.2
The good news is that student loans can be paid off early. There are no penalties for putting extra money toward your student loan debt, so if you can make additional or more frequent payments, you can keep the balance from getting too big. Especially if you have a high interest rate, it's better to pay off a student loan early. (However, if you owe money on your credit card and it carries a higher interest rate than your student loans, you may be better off putting money toward that debt first.) You can pay your student loans faster by following some simple tips.
It might come as a surprise that paying off your student loans may affect your credit score by lowering it slightly. One reason that happens is because part of your credit score is based on your mix of accounts. Student loans are considered installment loans, in which the balance starts out high and is gradually paid off. On the other hand, credit card debt is considered revolving debt because it starts out at nothing, then increases and fluctuates. When you pay off your student loans, your credit mix changes, and your FICO score takes a bit of a hit. But the drop tends to be fairly inconsequential, and you can boost it by using your credit card responsibly and paying your balance in full each month.
Repaying federal loans
All borrowers with direct loans or PLUS loans (either parent or graduate) can choose a standard or graduated repayment plan. On a standard repayment plan, you make fixed monthly payments for 10 years. This plan allows you to pay the least amount of interest, but your monthly payments can be high.
The graduated repayment plan is designed to reflect the natural growth in income over a person's career: Your payments will start out lower and increase every two years over a 10-year term. You will typically pay more overall on the graduated plan than on the standard plan.
If you owe more than $30,000 on your direct loans, you can choose an extended repayment plan, which allows you to make either fixed or graduated payments over a 25-year term. Because your payments are spread out over a longer period of time, you will pay less each month than under the standard or graduated plans. However, you'll pay more interest over the life of the loan.
Federal loans also offer a few income-driven repayment plans that include student loan forgiveness options, although most of these are not available to parent PLUS borrowers:
- Pay as You Earn (PAYE)—Payments are set at 10 percent of your discretionary income, up to a maximum of what you would pay per month under the 10-year standard plan. Any unpaid debt is canceled after 20 years. You must have a high debt-to-income ratio to qualify for this plan.
- Revised Pay as You Earn (REPAYE)—Payments do not exceed 10 percent of your discretionary income. Outstanding debt is forgiven after 20 years (for undergraduate loans) or 25 years (for graduate loans).
- Income-based repayment (IBR)—Payments are limited to 10 percent of your discretionary income. Your monthly bill is no more than what you would pay per month under the 10-year standard plan. Any remaining debt is forgiven after 20 years. To be eligible for this plan, your debt-to-income ratio must be fairly high.
- Income-contingent repayment (ICR)—Monthly payments are capped at 20 percent of your discretionary income. Under this plan, student loans are forgiven after 25 years. Note that parent PLUS borrowers can make use of this plan if they convert their PLUS loans into a direct consolidation loan.
So, depending on the type of loan you have and the repayment plan you choose, you have between 10 and 25 years to pay off student loans once deferment ends. According to one survey of graduates with bachelor's degrees, it takes about 21 years to pay off student loans, on average.5
The federal government also offers a couple of loan forgiveness programs for people in certain occupations:
- The Public Service Loan Forgiveness (PSLF) Program—Borrowers with direct loans who work full-time for government agencies or qualifying nonprofit organizations can apply to have their outstanding loans canceled after making 120 monthly payments. To be eligible for PSLF, you must use one of the income-driven repayment plans.
- The Teacher Loan Forgiveness Program (TLFP)—Highly qualified teachers who teach full-time in low-income schools for five consecutive and complete academic years can apply to have up to $17,500 of their direct loan debt forgiven.
Repaying private loans
Private loans come with a range of repayment periods, from as short as five years to as long as 30. A shorter term will generally mean a lower interest rate but higher monthly payments. On the other hand, if your payments are extended over a longer period of time, your monthly bills will be lower, but you will end up paying more in the long run.
Private loans are generally repaid using one of these types of plans, although not every lender offers each type:
- Immediate repayment—You start making payments on both the principal and the interest as soon as the loan is first paid out. That allows you to minimize your interest costs and pay off your loan sooner. However, many students find it difficult to make full payments while still in college.
- Interest-only—You pay the interest charges on your loan while you're still in school. That enables you to make smaller payments and keep your loan balance in check. (It won't go down, but at least it won't go up.)
- Partial interest—You pay a small fixed amount each month (typically $25 or $50) toward the interest on your loan while you are in school. That can help reduce the amount you owe in the long term.
- Full deferment—You postpone all payments until you are out of school. The interest still accrues, however, and will be added to your balance when it comes time to start making payments.
Private lenders do not offer income-driven repayment plans or loan forgiveness in most cases.
What to Do If You Have Repayment Problems
Many people run into difficulties when it comes to repaying their loans. If you fail to make a payment when it is due, you are considered delinquent on your loan. Being a few days late is not usually a serious problem. In most cases, lenders will only report delinquency to credit bureaus if you are more than 30 days late with a payment.
However, if you stop making payments for an extended time, you risk defaulting. With federal loans, you go into default if you let 270 days go by without making a payment. With private loans, you go into default at 120 days. About 10 percent of borrowers end up defaulting on their student loans.6
Defaulting can do major damage to your credit history and make it more difficult for you to qualify for home or car loans. Defaulting on a student loan can also render you ineligible for any further federal aid.
If you're struggling to make your monthly payments, contact your loan servicer (the company that collects your payments) to discuss your options. These may include:
1. Changing your repayment plan
If you have federal loans, the Department of Education allows you to switch payment plans at any time without paying a fee. Getting on a plan that ties your payments to your income, such as PAYE, REPAYE, IBR, or ICR, could be hugely beneficial. Depending on how much you earn, your monthly payment could even be as low as $0. Plus, you could have the balance on your loan forgiven after 20 or 25 years. Be aware, however, that there are tax implications when your debt gets canceled.
2. Requesting a deferment
A deferment allows you to temporarily pause your loan payments without incurring penalties. Most federal loans are automatically put into in-school deferment, meaning you do not have to make payments on them while you are still enrolled. If you have a subsidized loan, the government pays the interest during deferment. However, for all other types of loans, interest still accrues and will be added to your total loan amount.
With federal loans, you may qualify for a deferment if you are unemployed, serving in the military, experiencing economic hardship, or participating in a rehabilitation training program for the disabled. As of 2019, you can also qualify if you are being treated for cancer (and interest will not accrue during such a deferment). In most cases, deferments on federal loans can be for up to three years, though there is no time limit on deferments for military service.
3. Applying for forbearance
Like deferment, forbearance lets you temporarily suspend your monthly payments without facing penalties. The major difference is that you must pay all the interest that accrues during forbearance, even on subsidized loans. If you have a subsidized loan, deferment is a better option if you can get it.
With federal loans, forbearance can be mandatory (meaning your loan servicer is required to grant it) or discretionary (meaning your loan servicer can decide whether to grant it). In either case, it lasts for no more than 12 months at a stretch, but you can re-apply when the year is up.
You may qualify for mandatory forbearance if:
- You are completing a dental or medical internship or residency
- Your monthly payment amounts to more than 20 percent of your gross monthly income
- You are eligible for teacher loan forgiveness
- You are serving with AmeriCorps
- You are eligible to have your loans partially repaid through the U.S. Department of Defense Student Loan Repayment Program
- You belong to the National Guard but do not qualify for a military deferment
Discretionary or general forbearance may be granted if you are dealing with financial hardships such as a job loss or unanticipated medical expenses.
Private lenders set their own policies regarding forbearance. Some do offer it, but fees may be involved. It's important to understand that in the private sphere, "deferment" and "forbearance" essentially mean the same thing.
4. Consolidating your loans
If, like many students, you end up with multiple federal loans, you may want to combine them into a federal direct consolidation loan. This can be done for free. Consolidation can simplify your payments, since you will only have one monthly bill rather than several different ones. You will receive a new loan with a fixed interest rate that is weighted based on the rates of the loans you are consolidating, rounded up to the closest one-eighth of a percent. You will not receive a lower rate.
Consolidation loans can lower your monthly payment by extending your repayment period by several years. However, drawing out your payments means you will end up paying more on your loans overall.
Parents with PLUS loans who convert to a direct consolidation loan become eligible for the income-contingent repayment (ICR) plan, which sets monthly payments at no more than 20 percent of earnings. That can help make payments more manageable.
If you've defaulted on a federal loan, consolidation can help get you back on track. It will enable you to become eligible for federal benefits like forbearance, deferment, and loan forgiveness. You will also qualify to receive future federal aid. However, the default will remain on your credit record.
Note that private loans cannot be consolidated, but they can be refinanced.
5. Refinancing your loans
Private lenders offer borrowers the option to combine multiple loans into a single one, potentially with a lower interest rate. This is called refinancing. You can combine both federal and private loans this way. However, keep in mind that refinancing federal loans means losing access to benefits such as income-driven repayment plans and loan forgiveness programs.
Every lender sets its own refinancing requirements. Some may allow you to refinance even before you graduate, while others will require you to have a history of at least a couple years of on-time payments on your existing loans.
The interest rate you receive for your new loan will depend on factors like your credit score, job history, and income. You may be able to get a better rate if you have a cosigner with a good job and a solid credit record. You also might be able to score a better rate if you opt for a shorter loan term.
Like with consolidation, refinancing can allow you to lower your monthly payment by spreading your payments out over a longer term. However, that means you will end up paying more on your loans.
6. Declaring bankruptcy
If you've exhausted all of your other options, you might consider filing for bankruptcy. It is possible, though certainly not easy, to get rid of your student loans this way. Unlike most forms of consumer debt, student loans are not automatically discharged in bankruptcy. But there is a way.
As it currently stands, you must initiate what's called an adversary proceeding and demonstrate that paying off your loans would cause you "undue hardship." However, the law does not define what constitutes undue hardship, so that is left up to the courts. In 2018, the Department of Education began reviewing the definition in an effort to develop new guidelines that would make it easier for bankrupt borrowers to discharge student loan debt.
For now, most courts use the Brunner test. That means you must prove that:
- Repaying your loans would not permit you to maintain a minimum standard of living for yourself and your family.
- Your inability to maintain a minimum standard of living is likely to remain the case for a significant chunk of the loan repayment period.
- You have made good-faith attempts to repay what you owe.
If the court finds that you have proven undue hardship, your loans could be partially or entirely forgiven. However, filing for bankruptcy can be costly and will have a serious impact on your credit score. It should only be considered as a last resort.
How Do Student Loans Affect Taxes?
Many people don't realize the impact that student loans can have on their tax situations. Keeping in mind that tax rules can change at any time, here are a few things to be aware of:
1. You can deduct student loan interest.
The benefit varies depending on how much you earn, but you may be able to decrease your taxable income by as much as $2,500.
If the loan is in your name and your parent or another relative makes a loan payment for you, you can still deduct the interest on your tax return. However, if you are listed as a dependent on someone else's return, neither of you can claim the interest. Also, you don't qualify for the deduction if you are married but filing separately from your spouse.
2. You may have to claim canceled debt as income.
Student loans sometimes get written off. But student loan debt that gets canceled is generally treated as though you earned the money. That means if you default on your loan or have your debt forgiven as part of the terms of your repayment plan, you may have to report the discharged amount as taxable income. That can mean a hefty bill in April.
As an example, let's say that you borrowed $80,000 in federal loans and chose an income-driven repayment plan that required you to make regular payments for 25 years. Let's also suppose that when the 25-year term is up, you still owe $10,000. You will no longer have to make principal or interest payments on that $10,000, but you will have to add the amount to your income and pay the resulting tax.
3. Some student debt can be forgiven tax-free.
If you qualify for federal student loan forgiveness initiatives like the Public Service Loan Forgiveness Program or the Teacher Loan Forgiveness Program, any outstanding debt that is canceled is not taxable.
Also, federal student loan debt may be canceled without tax consequences if the borrower dies or becomes permanently disabled. Parent PLUS loans (where the parent is the borrower rather than the child) can also be forgiven if the child passes away. However, this provision is set to expire after 2025.
In some instances, private lenders will also forgive a loan in cases of death or permanent disability.
Be a Wise Borrower
It's important to understand how student loans work so that you can make an informed decision about how to finance your post-secondary education. Of course, it's also essential to carefully consider where you'd like to pursue that education. Did you know that trade schools, career colleges, and technical institutes offer a wide variety of streamlined programs that can help you develop job-ready skills for today's marketplace? Just enter your zip code in the school finder below to discover convenient training options near you!
1 Student Loan Hero, "Survey: Majority of Student Loan Borrowers Don't Know How Interest or Forgiveness Works," website last visited on November 20, 2019.
2 LendEDU, "Average Student Loan Debt Statistics by School by State 2019," website last visited on November 20, 2019.
3 New America, Decoding the Cost of College: The Case for Transparent Financial Aid Award Letters, website last visited on November 20, 2019.
4 Bureau of Labor Statistics, U.S. Department of Labor, Occupational Employment Statistics, website last visited on November 20, 2019.
5 One Wisconsin Institute, The Impact of Student Loan Debt on the National Economy, website last visited on November 20, 2019.
6 U.S. Department of Education, Federal Student Aid, "Official Cohort Default Rates for Schools," website last visited on November 20, 2019.