A college education could be the most important investment for a child’s future. It’s quite a big investment that can run into the tens of thousands of dollars or more. Most students will need to borrow money in order to afford a college education. Because college is demanding, few students will have the time to work and earn enough money to pay their tuition at the same time they attend college. And that’s where student loans come in.
Understanding how student loans work is not easy because of the different types of student loans. This guide is meant to help you understand the “what are student loans?” question.
As with any type of loan that could impact you financially over a lifetime, it’s important to do your research. Doing your homework on how student loans works and knowing what options are available by knowing the pros and cons of the different types of student loans can save you thousands of dollars in debt and future financial stress.
What are student loans?
Student loans are a borrowing option designed to help college students pay for their school tuition, books, and living expenses. Often, the repayment schedule for student loans is deferred (delayed) until after the student graduates or leaves college so that they can focus on their studies and not having to worry about out how to pay the loan while attending classes.
How student loans work
Getting student loans are a complicated process. There are different types of student loans available, all with their own way of working. In order to get started with student loans, the first thing all students should do each year before they apply for student loans is to fill out the Free Application for Federal Student Aid (FAFSA). It’s a requirement for any federal student loans or parent loans. This FAFSA application is also used by colleges to make decisions on grants (free funding) and other types of financial aid products like work-study programs.
Different types of student loans
There are four basic types of student loans:
- Federal loans made directly by the U.S. government.
- Federal loans made by banks and guaranteed by the U.S. government.
- Private loans from banks and lenders that carry no government guarantee.
- School trust-fund types of loans made by colleges loans in partnership with a bank.
Students should aim for direct federal loans or bank loans backed by the federal government because the interest rates on these loans is capped at a cheaper, fixed rate set by Congress.
Let’s get into more details about the four different types of student loans.
Federal student loans
Federal student loans are the best option because they come with fixed interest rates and better repayment terms. Federal student loans allow a student to pay less of the loan off in the early years as they get into the job market. Repayment plans allow the student borrower to make payments for up to 25 years. Anything owed after 25 years can be forgiven and written off.
Three different types of student loans that are Federal include:
- Direct Stafford Loan: The lowest cost of student borrowing options.
- Federal Perkins Loan: A type of need-based loans. A school will notify a student if they are eligible for a Federal Perkins Loan after they review their FAFSA student aid application.
- Federal PLUS Loan: A college student loan that is designed for parents who want to borrow money to help their kids.
Besides the different types of federal loans, they can break down further into two separate categories of subsidized or unsubsidized. Whether a loan will qualify as either subsidized or unsubsidized depends on the FAFSA student aid application.
Direct subsidized vs. direct unsubsidized student loans
Direct subsidized loans from the federal government should be the priority for any student shopping for student loans. In this type of student loan, the U.S. Department of Education will pay all the interest while the borrower is still a student as well as a number of months after graduation so the student can get their careers in order after graduation.
A student should avoid unsubsidized loans because they add more debt to a student’s loan while they attend school. If they don’t make interest payments while in school, the interest builds up as loan principal and increases the loan amount.
Private student loans
If a student can’t get enough money to cover their college education and expenses through grants and the available federal student loan programs, their other option will be to apply for private student loans. Private student loans are closer to tradition loans. They are usually more expensive with higher interest rates that are variable instead of fixed. These private student loans are not part of the federal government’s repayment program. A borrower will be held liable for this loan whether they can afford to pay it off or not.
School trust fund loans
Some private colleges offer loans through a school trust fund. These are usually in partnership with a bank. The loan terms from a school trust fund loan will often be better than the terms from a private student loan.
Students and their parents should plan carefully as to how much they are willing to borrow for school. It’s important to set themselves up for a future without too much debt. This may mean skipping the four year private college dream, which may be too expensive. A good, affordable option to four years of private college would be the first two years at a state or community college followed by the last two years at the private college of choice.
Before students and parents borrow, they should look at grants, help from family and a work-study program as ways to pay for college. If they must borrow, a federal secured student loan is the best choice. A good rule of thumb is to borrow less than their first year’s salary. More than that could mean many years of student loans payments for more than they can afford.