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Student loans 101 Everything from how much to borrow to paying it off

Alex Thomas Sadler

It’s no secret that student loan debt in the U.S. has become a big problem — with 43 million Americans now owing a total of more than $1.2 trillion in education loans.

That’s a lot of money — so much that it’s difficult to even grasp what $1.2 trillion means.

So let’s forget about those statistics and talk about what matters most to you — how student loan debt affects your life and your money.

I’ve been trying to come up with the best analogy to describe student loan debt, and I think I’ve finally found one: It’s like a never-ending hangover.

In college, it’s easy to avoid it with a little hair of the dog and continuing to do your thing. In fact, student loan debt is something most people don’t start to pay attention to until after school.

Someone once told me: “The hangover makes the fun the night before not worth it.”

Pretty good advice, if you ask me.

So when it comes to student loan debt, you have to make sure you understand it in order to make the “fun the night before” — i.e. the education that will lead you to a more successful future — worth it!

Student loans can be a great investment — you’re investing in your education in order to get a better, higher-paying job down the road.

But if you don’t know exactly what you’re getting into, that investment could end up costing you more than it’s worth.

One of the biggest problems with student loan debt in America is the lack of understanding of how the process works from start to finish. When many people graduate college, they are in for a big surprise when those student loan payments start coming in.

So it’s crucial that you actually understand your loans — for two reasons:

  • so you don’t suddenly get slapped in the face by them,
  • and so you can make the best choices for you and your situation, including the best ways to get the debt paid off.

To help you get a better grasp on student loans and how it all works, this guide is broken down into four main parts:

  • The types of loans available and how they work
  • Which loans are the best
  • The 3 rules of borrowing
  • Options for paying off student loans

This is not a college test — so you don’t need to know every single thing, you just need a little Common Cents.

Types of student loans

When it comes to borrowing money for college, there are two main types of student loans: federal and private.

  • Federal student loans: These are issued by the government and pretty much anyone with a high school diploma can apply for one and get it.
  • Private student loans: These are issued by private banks or other financial companies. With a private loan, you borrow money directly from the bank instead of the department of education.
    • Private loans are typically a very bad idea — they have really high interest rates and the repayment options are a lot less generous than federal loans.
    • If you asked Clark Howard, he would tell you to stay as far away from private student loans as possible — but we’ll get more into that down below.

Now let’s take a closer look at federal and private loans and how it all works.

Federal student loans

If you need help paying for college, which most people do these days thanks to the increasing costs of higher education, the very first step to fill out a form called the FAFSA — Free Application for Federal Student Aid.

The information on your FAFSA is what the government and schools use to determine your eligibility for financial aid, which includes a few different things.

Financial aid is money given to you to cover the cost of school — and it can come in the form of grants, work-study, student loans and even scholarships.

In previous years, the process usually started in January, but for the 2017-18 academic year, the FAFSA will be available in October of 2016, and students will be required to submit their form between October 2016 and June 30, 2017.

The earlier a student submits the FAFSA the better. Schools have a limited amount of money to give out, so the earlier you submit your application, the better chance you have of receiving money.

Filling out and submitting the FAFSA is free — so don’t let a scammer try to tell you otherwise. Just go to fafsa.gov to start the process and get more information about how it works.

According to the U.S. Department of Education, here’s what you’ll need:

  • Your Social Security Number
  • Your Alien Registration Number (if you are not a U.S. citizen)
  • Your most recent federal income tax returns, W-2s, and other records of money earned. (Note: You may be able to transfer your federal tax return information into your FAFSA using the IRS Data Retrieval Tool.)
  • Bank statements and records of investments (if applicable)
  • Records of untaxed income (if applicable)
  • An FSA ID to sign electronically.

If you are a dependent student, you will need all of your parents’ information listed above. Here’s a chart to help you determine whether you are a dependent or independent student.

Financial aid is used to cover things like tuition, housing and school supplies – and while some types of aid don’t have to be paid back, others do.

If you’re awarded a grant, that money is free — so you don’t have to pay it back.

But grants are typically smaller amounts of money, so even if you get one, you will likely still have to take out student loans — which you do have to pay back.

Work-study opportunities allow students to work for the school to cover a portion of their tuition. And scholarships are like grants, if you’re awarded a scholarship, you don’t have to pay the money back.

Here’s a list of some of the best ways to find scholarship opportunities.

Types of federal student loans

There are several types of federal student loans. After you submit your FAFSA, you will know which types of loans you are eligible to receive.

The most common type of federal loan is a direct loan — also known as a Stafford Loan.

  • Stafford loans have a fixed interest rate and the amount you get depends on your needs.
  • There are two different types of Stafford loans — subsidized and unsubsidized.
    • Subsidized Stafford loans: These loans don’t start accruing interest, and don’t require you to make any payments, until six months after you graduate.
      • The fact that interest doesn’t kick in until after school is what makes these loans a great deal.
      • How much you can borrow depends not only on your needs, but also on your year in school, so the limit is different for freshman year, sophomore year etc.
      • Subsidized Stafford loans are reserved for people who have a greater financial need – so depending on your situation, you may not qualify for enough in subsidized loans to cover the total cost of college, which means you would borrow the remaining amount through another type of federal through.
    • Unsubsidized Stafford loans: These loans are available to more people and also don’t require borrowers to start making payments until six months after graduation. Unlike subsidized Stafford loans, unsubsidized loans do accrue interest while you are in school.

So the biggest difference between subsidized and unsubsidized loans is when the interest starts accruing.

What does that even mean? When interest accrues, or accumulates, that means a percentage of the total amount, based on the interest rate, is added to the total balance each month. So while you’re in school and not required to make any payments toward your loan, if it’s an unsubsidized loan, when you graduate the total loan amount will be more than what you borrowed.

Here’s an example:

  • You borrow $20,000 in unsubsidized federal loans.
  • The interest rate on these loans right now is 3.76 percent.
  • During 4 years of school, 3.76 percent interest is added to the balance each month.
  • As the balance increases, the interest charge gets higher, since it’s a percentage of the total balance.
  • After 4 years of school, $3,008 in interest accrues.
  • Total amount owed after graduation: $23,008.

So if you don’t pay off those interest charges while you’re in school, you’ll end up paying interest on the interest, because it’s added to the total balance the entire time you’re in school. Although you aren’t required to pay interest during school, you can request to receive bills from your loan servicer for the interest payments, if you can afford to cover it during those years.

Interest rates on federal loans right now are pretty good — just a few years ago, the interest rates were around 6.8 percent, which is why so many people who graduated years ago are still struggling to pay off student loan debt.

  • Direct PLUS Loans: These are another type of federal loan that are available to graduate and professional students — as well as to parents of undergraduate students to help pay for costs that aren’t covered by financial aid (grants, work-study, scholarships, Stafford loans).
  • Another type of federal loan is a Perkins loan: Perkins loans are available to students with more extreme financial need.
  • With a Perkins loan, you borrow money through your school’s program, so the school is the lender.
  • If you qualify, the amount depends on how big your needs are and how much money the school’s program has to give out.
  • Also, not all schools have this program.

Federal student loans typically come as a package of loans. So one student loan borrower can have a few different loans, depending on how much money the individual is eligible to receive in each type of loan.

For example, let’s say you qualify for a certain amount in subsidized Stafford loans but it’s not enough to cover everything — then you may also have to borrow another amount in unsubsidized Stafford loans. And the loans may actually be broken down even further — into four different, smaller loans (two amounts for each two types of loans) — but it just depends on your situation.

The reason this is important is because a lot of people get really confused when they go to look at their loan balance and see four different balances. If you have two subsidized loans and two unsubsidized loans, when you graduate, the unsubsidized loans will be a lot more than the subsidized ones, because they were accruing interest the whole time you were in school.

So when payments kick in six months after graduation, you don’t want to get a big surprise when you realize that two of the loans are be bigger.

Private student loans

When you’re borrowing money for college, private loans are the worst type of student loans.

Here’s why:

  • Private student loans have much higher interest rates — so they’ll cost you a lot more over time.
  • When it comes time to pay them back, there’s really no wiggle room and you don’t have any of the repayment options available for federal loans that can help you with your loan payments.
  • Private lenders aren’t really there to help you through obstacles during your repayment period — they will come after you for that money.

So hopefully you now have at least an idea of how each loan works.

Now let’s take a closer look at your best options.

Your best student loan options

It’s probably clear that a private student loan is not your best option — and pretty much 100 percent of the time, it will never be your best option.

So let’s look at your best options for federal student loans.

  • Your best option is a subsidized Stafford loan.Here’s why:
    • The interest is paid by taxpayers while you’re in school, so no interest will be added to the loan balance until after graduation.
    • You don’t have to start paying it back until six months after you graduate.
    • So after six months, you’ll owe the amount you borrowed and then interest moving forward.
    • You can also delay your payments through a deferment – which is a period of time, typically between 1-3 years depending on your situation, when you don’t have to make any payments toward your loans. Also during that period, no interest is added to the total loan amount.
      • This option is only available for subsidized and Perkins loans – not for unsubsidized loans.
    • You can also delay or reduce your payments through forbearance. Forbearance may allow you to stop making monthly payments on your loans or reduce the amount of your monthly payments, for up to 12 months. But interest does accrue during a forbearance period, so keep that in mind.
  • Your next best option is unsubsidized Stafford loans.

    Once you’ve reached the limit on the amount of subsidized Stafford loans you can borrow, your next best option is unsubsidized Stafford loans.
    • Even though it’s your second-best option, you want to borrow as little as possible in unsubsidized loans.
    • Because remember – with UNsubsized loans, the interest accumulates while you’re in school.
    • So when you graduate, you already owe a lot more money than you borrowed.
    • With unsubsidized loans, you don’t have the option of deferment, but you do have the option of forbearance, which can help you get through a difficult time or help you afford your monthly payments by reducing them for a period of time. Just know that when the period is up, your monthly payments are going to jump back up – to more than you were required to pay before the forbearance – in order to keep your repayment schedule on the same timeline.
  • As a third option, parents can help their kids by taking out PLUS loans.
    • These loans do have a higher interest rate – about double the rate for Stafford loans – but if a student has reached the borrowing limit on Stafford loans, this is where a PLUS loan can help.
    • And a parent can borrow up to the cost of attendance.

The 3 rules of student loan borrowing

  1. Never borrow more for a 4-year degree than the entry-level salary you expect to earn during the first year after graduation.If you know what you want to study and figure out that in your first year after graduation, you won’t be able to earn as much money as you would have to borrow, consider an alternative.
  2. Consider doing your first two years at a community school and transferring to a four year school for the last two years.Then after two years, you can transfer your credits to the school from which you want your degree. That can save you as much as 50% on the total cost of college Just make sure to do some research to make sure that you will be able to transfer those credits to the school of your choice. And by the way, no one asks you where you started college – just where you graduated from.
  3. Never borrow any private student loan money! Can’t say it enough. If the cost of the degree you want exceeds what you can borrow under the federal student loan program, you should either pick a cheaper school, work your way through school or start at a community college and transfer.

Bonus tip: Only borrow what you absolutely need! You may qualify for a bigger loan amount than you actually need, but that doesn’t mean you should take it. If you work your way through school, you can avoid borrowing too much in student loans and make your life a whole lot easier down the road.

How to pay off student loans

One thing about student loans is that they’re easy to forget about. Some people might say that’s crazy, how could you possibly forget that you owe $50,000?? Or whatever the amount is.

But since many loans don’t require any payments while the borrower is in school, it can be easy to forget that they’re even there. On top of that, many college students have no idea what they’re about to face when they graduate — especially since so many don’t even know what types of loans they have, how they work and if they’re being charged interest or not.

And if you don’t know, that’s OK! Now that you have an idea of what to look for and how each loan works, you can start to better understand your own loans.

Paying student loans while you’re in school

If you’re still in school and you have loans that are accruing interest, try to pay off the interest payments each month in you can. You’ll have a better idea of what you’ll face when you graduate and you’ll also owe less money when that time comes.

Picking up a side job while you’re in school can help you make those payments and also put some money away in savings.

Paying attention to your student loans will help keep you on track and also help you avoid getting way behind on payments.

Paying student loans after you’ve graduated

If you haven’t taken the time to sit down and actually look at your loans and how much you owe — it’s time to rip off the Band-Aid!

It can be a little terrifying, which is why so many people choose to put it off. But if you don’t have an idea of what you’re facing, it will take you a lot longer to get your loans paid off and they’ll cost you a lot more money over time.

Understanding the interest on your loans

Several years ago, I made myself sit down and look at all the details of my loans — I cried and freaked out a little bit, but then I got it together and started going through every detail of my loans.

And what I discovered was that a huge chunk of my monthly payments was going toward interest — not even the actual loan, just interest!

If you’re facing some pretty hefty loans, just thinking about looking at all of the details can be kind of miserable, especially if you don’t have the money to pay them off anytime soon.

It’s easy to simply set your monthly payments on autopilot and never look back. But while that’s a good way to make sure you don’t miss any payments, ignoring the big picture may be costing you more than you think.

Just like other loans, interest is the fee you pay the lender for letting you borrow the money — and it’s calculated daily, based on the loan’s interest rate.

So if you’ve been making monthly payments for a while and are wondering why the total balance has barely gone down at all, you need to take a closer look at what you’re paying in interest.

Let’s say you have a $50,000 loan with an interest rate of 7 percent. Here’s how to calculate your daily interest rate:

(interest rate) x (current principal balance/total loan balance) / (number of days in the year) = daily interest

So using the same example:

.07 x 50,000 / 365 = $9.58

That means you would be paying $9.58 per day in interest! If your minimum monthly payment is $500, in a 30-day month, you would be paying $287.40 in interest alone, which means only $212.60 of that payment is going toward the actual loan balance.

It sucks, but it’s just how student loans work. When you make a payment, the lender applies the money to different parts of your loan in a specific order, so once the first thing is covered, the remaining amount of the payment is applied to the next thing and so on. Here’s the order:

  • Late fees
  • Interest
  • Principal

So when you’re just making the minimum monthly payments on a big loan with a high interest rate, that balance isn’t going down anytime soon.

Go through your loans to see what you’re paying in interest and how your monthly payments are being applied, because even if you’re paying hundreds of dollars each month, you may not even be making a dent in the total cost of your debt.

So that’s something you really need to pay attention to!

If you can afford to pay more each month, do it. And if you have several loans, put the most money each month toward the loans with the highest interest rates, while still making the minimum payments on the other loans.

You also need to know your options — because there are a lot of programs that can help you pay back your loans — IF you only borrowed federal student loans.

So here are a few of those options — and again, these are not available for private loans — only federal student loans.

Federal student loan repayment programs

If you have federal student loans, there are some options available that you may be able to take advantage of.

  • Income-based repayment: Income-driven repayment plans help borrowers keep their loan payments affordable with payment caps based on their income and family size. There are now four types of these plans available: Income-Based Repayment (IBR), Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE) and Income Contingent Repayment (ICR).After you qualify, your monthly payment may be adjusted each year based on changes in income and family size. You will have to verify your income every year, which means if you start to make more money, your payments may go up.
  • PAYE – Pay As You Earn – Caps monthly payments at 10% of your income; all debt is forgiven after 20 years of on-time payments.
    • Important note: If you took out loans before 2007, your payments are capped at 15% — and you must pay on time for 25 years to have your loans forgiven.
  • Loan forgiveness: In addition to repayment options, there are also ways to have your student loans forgiven. Public service employees can qualify for full loan forgiveness after making 10 years of monthly payments on their federal student loans. Get more details to see if you qualify.

There are also other options like deferment and forbearance, which allow borrowers to postpone their payments if they’re struggling to even get by or due to other economic hardships.

  • Deferment: A deferment allows you to postpone your loan payments for anywhere between 1 and 3 years, depending on your situation. For Perkins and subsidized Stafford loans, the advantage of deferments is that interest does not accrue during that period while you aren’t making payments.But for unsubsidized and PLUS loans, interest does accumulate during deferment. So if you don’t pay the interest charges during that period, they are applied to the total loan balance and when the period is up, your monthly payments will be higher than they were before deferment, because of the added interest.
  • Forbearance: If you can’t make your monthly loan payments but don’t qualify for deferment, your lender may grant you a forbearance period. With forbearance, you may be able to delay your payments or reduce your monthly payment for up to 12 months.But! With forbearance, interest will continue to accumulate on every type of loan — including subsidized, unsubsidized and PLUS loans.

So if you don’t pay the interest charges during that period — on subsidized, unsubsidized or PLUS loans — the fees are applied to the total loan balance throughout the duration of your forbearance. Then when the period is up, your monthly payments will be higher than they were before, because of the added interest.

These options can help you when you’re struggling to make your monthly payments, but just keep in mind that if interest is accumulating, you should try to continue paying off the interest while your monthly payments are delayed.

Federal loan consolidation

After you’ve exhausted all of these options, you may want to consider federal loan consolidation.

A Direct Consolidation Loan allows you to combine multiple federal student loans into one loan – so you would have one single monthly payment instead of multiple payments.

Before you consolidate your loans, there are a few things to consider.

Pros of loan consolidation

  • Simplifies your student loan repayment with one monthly bill.
  • The new loan may extend your repayment period by 10 to 30 years, giving you more time to pay it off.
  • Consolidation may make you eligible for repayment plans you couldn’t previously qualify for.
    • If your current loans don’t qualify you for income-based repayment plans, consolidating them into one federal Direct loan could allow you to take advantage of this offer, which means your payments would be tied to your income and the total loan balance would be forgiven after 20 to 25 years of on-time payments.
    • The same goes for federal student loan forgives programs.
  • While some of your loans may have a variable interest rate, the new loan will have a fixed rate.

Cons of consolidation

  • By extending your repayment period, you will have to make more payments and pay more in interest (although you could always just pay the loan off faster than the scheduled repayment term).
  • Your monthly payments may also increase, so make sure to compare your current monthly payments to what you would be required to pay each month on the new, consolidated loan.
  • When you consolidate, you lose any borrower benefits that were offered with your original loans.
  • If you have a Perkins loan, those come with their own cancellation programs – so if you consolidate, you may want to keep the Perkins loan separate in order to take advantage of the cancellation program.
  • Once you consolidate, it cannot be undone.

Federal loan consolidation is FREE — so do not let a company, scammer or anyone try to charge you for consolidating your loans for you.

For more details on all of the federal student loan repayment options available to you, including loan consolidation, check out the Federal Student Aid website.

Refinancing student loans

After you’ve exhausted all of these options, or if you have private student loans, that’s when you may want to consider refinancing.

Student loan refinancing has become an increasingly popular way for borrowers to decrease the total cost of their debt — while shrinking the time it takes them to get it all paid off.

While borrowers didn’t used to have many options, unless their degree or career made them eligible for programs like loan forgiveness, there are now several lenders offering student loan refinancing.

Here’s how it works: The lender pays off your current loan and issues you a new, private loan. Then from that moment on, you pay the private lender.

Refinancing can be tricky, especially if you have federal loans, because refinancing means you’re moving from a federal loan to a private one – and we made very clear earlier in this guide that private loans are a bad idea.

What to consider before choosing to refinance

As a general rule of thumb, you really don’t want to refinance federal student loans until it’s your absolute last option.

So before you decide to refinance, there are a few things to keep in mind to make sure it’s the best option for you. And this is crucial, because you don’t want to refinance and then realize you just made your situation even worse.

Make sure to do your research and find out if you are eligible for any of the federal programs listed above. Once you refinance to a private loan, all of those options go away and you’re stuck — so you just want to make sure you don’t miss out on any opportunities already available to you, including repayment plans, loan forgiveness, forbearance, deferment, consolidation etc.

Once you’re issued a private loan, the rules change. There is no wiggle room on repaying that loan and private lenders really have no interest in helping you figure out your situation — so there is no negotiating your monthly payments or anything else.

Now, what if you’re past the point of being able to take advantage of postponing your payments and you’re making too much money for an income-based plan to do you any good?

That’s when refinancing may be an option — and it’s available for both federal and private loans.

Keep in mind, good refinancing offers typically aren’t available to people with poor credit, often not even for people with fair credit.

But if you don’t qualify for a good offer that makes sense, that doesn’t mean you won’t be able to get a good offer down the road.

When should you consider refinancing?

If you aren’t sure whether you should refinance your student loans, here are some situations when it can be beneficial.

1. You want a lower interest rate

If you took out federal student loans when interest rates were high — like 6.8 percent— or maybe you took out private loans to pay for costs that federal loans didn’t cover, then you may want to consider refinancing. Refinancing will allow you to take advantage of lower interest rates that weren’t available when you originally took out your loans.

2. You have great credit (or a co-signer)

Lenders offering student loan refinancing use several factors when determining whether they will give someone a loan, including credit score, income, educational background and employment history. The importance of each factor is different for each lender, but as a general rule, you’ll get better offers — with lower interest rates — if your credit score is in the 700s or 800s. You may be able to get a decent deal with decent credit, but your offers will depend on a combination of all of those factors.

If you have poor credit, you can use a co-signer to get better refinance offers.

3. You have a solid income

Even if you don’t have stellar credit, having a solid income relative to your debt can help you get a good refinance offer. But it’s important to note that lenders will factor your total debt into their decision — so not just your student loans, but also any credit card debt and other loans you have, like a car loan. So if you’re making $70,000 a year, but you have $100,000 in total debt, you may need a co-signer to get a really good refinance offer.

If you don’t qualify for a good offer now, because you have other debts to pay off, start paying extra toward those debts now, in order to reduce them as quickly as possible. Then once you get those down, you can apply for refinance again in a few months.

Who should not refinance student loans?

If you have not tried or used all the available federal student loan repayment options, do that first – before you consider refinancing.

How to save the most with refinancing

The main reason people refinance is to get a lower interest rate, but there’s another part of the process that can save you even more.

Refinancing to a lower rate can save you money over time, but choosing a shorter loan term is what will save you the most. The down side is that it will increase your monthly payments, but with a shorter term, you’ll get your loan paid off quicker — and at an even lower cost.

If you can afford the higher amount, choose the shorter loan term to save more on the total cost of your loan.

If you can’t afford the higher monthly payments, you may want to reevaluate your budget and put off refinancing until you can. Because once you agree to those bigger payments, there’s no going back.