How Do Student Loans Work? (A Crash Course for Would-Be Borrowers)
Note: This is the third post in the Financial Aid Fundamentals series. Here we learn more about three types of student loans in the federal financial aid program.
In the first post in this series, we learned some financial aid basics, including the five sources of financial aid and the common types of financial aid.
In the second post, we described how financial aid works. We learned about need based and non-need based aid and about financial aid disbursement.
In this post, we review one type of financial aid: federal student loans. If you’re preparing for college (and perhaps even if you're already there) you might be wondering: how do student loans work?
In my experience, most students know they have to pay back loans, but they're usually fuzzy on the details, like what kind of student loans they have or what their student loan repayment options will be.
This post addresses some of those questions. While there are private student loans, we focus here on loans through the federal financial aid program, which are the most commonly used type of student loans.
But first let’s learn a bit more about the federal student loan program.
The Federal Student Loan Program
The federal student loan program is governed by a set of laws known as Title IV. If you hear someone on campus mention “Title Four Funds” they're talking about student loan money.
The biggest Title IV program is the William D. Ford Federal Direct Loan Program, commonly called the Direct Loan program or just Direct Loans.
How Do Direct Loans Work?
Under the Direct Loan program, federal student loan money is sent directly to your school. Your school uses the money to pay your tuition, fees, books, and housing (if you live on campus), plus any other bills you owe the university.
Once all your university bills are paid, the school gives you any remaining student loan money. This is called a financial aid disbursement.
Colleges and universities will disburse your extra Direct Loan money at least once a semester. Most give you the option of having the money directly deposited into a bank account.
Which Federal Student Loans Are Direct Loans?
There are three Direct Loans that can help you pay for college: federal subsidized loans, federal unsubsidized loans and federal PLUS loans. Even though they’re part of the same program, the requirements for the three loans are different. We’ll look at each loan in detail here, beginning with federal subsidized loans.
Federal Subsidized Student Loans
Federal subsidized student loans are need based financial aid, meaning your/your family’s overall financial situation is taken into account when determining if you qualify for this type of loan.
Who Qualifies for Federal Subsidized Student Loans?
Only undergraduate students qualify for federal subsidized loans. They must be enrolled in a two year or four year school, community college, or trade/technical school and must fall within the income guidelines set by the financial aid program.
Why Is This a "Subsidized" Student Loan?
These are called subsidized loans because the government pays interest on the loans as long as students stay enrolled at least half-time. That means the government is subsidizing the cost of the loans while students are in school.
How Much Federal Subsidized Student Loan Money Can You Borrow?
The amount of money you can borrow in federal subsidized student loans depends on how long you’ve been in school.
Currently (2019), first-year students can borrow a maximum of $3,500 a year in federal subsidized loans, while juniors and seniors can borrow up to $5,500 a year.
But even if you qualify for federal subsidized student loans, you may not receive the maximum amount. Remember, federal subsidized loans are need based aid and your total need based aid can’t be more than your financial need. If your financial need is estimated at $1,800 that is the maximum amount you can borrow in federal subsidized student loans each year.
How Long Can You Borrow Federal Subsidized Student Loans?
Students enrolled in two-year programs can usually get subsidized loans for a maximum of three years. Students in four-year programs can usually get subsidized loans for a maximum of six years.
These time limits are known as your maximum eligibility period. Your maximum eligibility period applies to your total time in school; the clock doesn’t reset if your circumstances change.
For instance, if you change your major or transfer colleges after you’ve taken out your first federal subsidized student loan, you’re still within your original eligibility period and the time limits still apply.
So, if you decide to change your major or you want to transfer colleges, make sure you can finish your degree before your maximum eligibility period runs out.
Federal Unsubsidized Student Loans
Federal unsubsidized student loans are non-need based financial aid. That means you can qualify for an unsubsidized loan regardless of your/your parents’ income. This is just one way unsubsidized loans are different from subsidized loans.
Subsidized vs. Unsubsidized Student Loans
While subsidized federal student loans are only available to undergraduates, unsubsidized federal student loans are available to both undergraduate and graduate students.
Unsubsidized loans do have the same enrollment requirement as subsidized loans, but unlike subsidized loans, students are responsible for paying the interest on these loans, even while they're still in school.
Another big difference is that, unlike subsidized loans, there's no time limit on how long you can get federal unsubsidized loans. However, there is a limit on the total amount of unsubsidized loan money you can borrow. The current cap on federal unsubsidized loans is $34,500 for undergraduate students and $73,000 for graduate students.
Who Pays Interest?
Government, while borrower is
Borrower at all times
Maximum Period of Eligibility
The major differences between federal subsidized and unsubsidized student loans.
Federal PLUS Loans
Like federal unsubsidized student loans, federal PLUS loans are also non-need based financial aid. PLUS loans are a type of unsubsidized loan available to students in graduate and professional school. Parents of undergraduate students can also get PLUS loans.
Graduate PLUS Loans
Unlike other Direct Loans, PLUS loans require a credit check. This means borrowers must have a good credit history to get a federal PLUS loan. Poor credit history doesn’t automatically disqualify student borrowers, but does make it harder for them to get a loan.
If students have bad credit, they may be required attend credit counseling in order to get a PLUS loan. Students with bad credit may also have to get an endorser (also known as a co-signer) to get a PLUS loan. The co-signer agrees to repay the loan if the student does not.
Parent PLUS Loans
Parent PLUS loans let parents borrow money to help pay for their child’s education.
The maximum amount of Parent PLUS loan money you can get each year is the cost of attendance minus any other financial aid. That means parents can only borrow enough PLUS money to cover the gap between the cost of college and any grants, scholarships and loans their child has gotten on their own.
As with Graduate PLUS loans, Parent PLUS loans require a credit check. In this case, parents’ credit is checked, since they're the borrowers. Bad credit won’t automatically disqualify parents from getting a PLUS loan but they may be required to undergo credit counseling and get a co-signer for the loan.
In the fourth part of the Financial Aid Fundamentals series, we’ll look at the federal parent PLUS loan program in deeper detail. As college costs keep rising, more families are turning to this type of loan, which is very different from other federal student loans. We’ll learn more next time in the Informed Parent’s Guide to Federal PLUS Loans.
Have questions about student loans? A student loan story of your own? We’d love to hear from you in the comments.