How Do Student Loans Work? 7 Things to Know

Written by |

If you’re considering going to college but aren’t sure how you’ll pay for it, you might be wondering if student loans are a good idea.

In this article, we’ll cover how student loans work, who should consider applying for them and the traps you need to avoid when taking out student loans.

We’ve gotten some great advice from a student loan expert, and money expert Clark Howard weighs in with his thoughts about student loans and taking on student loan debt.

What You Need to Know About Student Loans Before You Apply

Table of Contents

  1. What Are Student Loans and How Do They Work?
  2. What Is the Difference Between Federal and Private Student Loans?
  3. What Are the Different Types of Federal Loans?
  4. How Do You Apply for Federal Student Loans?
  5. How Much Money Can You Borrow?
  6. How Much Interest Will You Pay?
  7. How Do You Pay Student Loans Back?

1. What Are Student Loans and How Do They Work?

Student loans are loans that can help people pay for studying at post-secondary institutions like colleges, universities and some technical schools. You can typically take out these loans for both undergraduate and graduate programs.

Student loans are intended to fill the gap between what you can afford to pay for education and what it actually costs. These loans shouldn’t be confused with financial aid, scholarships and grants, which don’t have to be paid back.

When you take out a student loan you will be expected to repay the money you borrow, plus interest.

Because of that interest, you should only consider taking out student loans if you’ve run out of other options.

The first thing students and parents should know is that borrowing should be a last resort,” certified student loan counselor Andrew Pentis of Student Loan Hero told “Only [apply for them] after using college savings accounts, applying for state grants and private scholarships, even taking on part-time jobs and working out tuition payment arrangements with the schools.”

2. What Is the Difference Between Federal and Private Student Loans?

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

Federal student loans are issued by the government. Most people with a high school diploma or GED are eligible to apply for federal student loans, though there are some other requirements to meet. We’ll get into the details of the available federal student loans in the next section.


Private student loans are issued by banks, credit unions or other financial companies. With a private loan, you borrow money directly from the institution rather than the government.

Clark is not a fan of private student loans.

“I want you to avoid private student loans at all costs,” he says. “Back in 2005, the private student loan industry bought off enough politicians to gain the right to do any and all tactics short of causing you bodily harm in their efforts to collect on their money. You have no wiggle room when it comes to repayment options like you do with federal loans. Private student loans typically can’t even be dismissed in bankruptcy.”

Here are some other reasons to steer clear, according to Clark:

  • Private student loans typically — but not always — have higher interest rates than federal loans, so they’ll cost you a lot more over time.
  • Private lenders aren’t really there to help you through obstacles during your repayment period — they will come after you for that money.

3. What Are the Different Types of Federal Loans? 

Federal student loans have undergone some changes in recent years, but there are currently some different options for students looking to borrow from the government.

Primary Types of Federal Student Loans Available for 2023-2024

Loan typeInterest rateAmount you can borrowDoes interest accrue while in school?
Direct Subsidized Loans5.50% (Undergraduate students)$3,500-$5,500 annually depending on student yearNo
Direct Unsubsidized Loans5.50% (Undergraduate students)

7.05% (Graduate or professional students)
$9,500-$12,500 annually depending on student year for undergraduates

$20,500 annually for graduate students
Direct PLUS Loans8.05%Up to the cost of attendance minus any other financial aid the student is receivingYes

Direct Subsidized Loans

All Direct loans have a fixed interest rate and the amount you get depends on your needs. The limit to the amount you can borrow increases as you progress in your studies so juniors are able to borrow more than freshmen, for example. These loans don’t start accruing interest while you’re in school and don’t require you to make any payments until six months after you graduate.

Direct Subsidized loans are intended for people who have an even greater financial need. 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 somewhere else.

Clark says that Subsidized loans are the single best source of money you can borrow for school. The interest is picked up by taxpayers while you’re getting your education. New Subsidized loans carry a fixed interest rate starting at 5.50% for the 2023-2024 school year.

Direct Unsubsidized Loans

If you still need money after you reach your subsidized Stafford loan limit, Clark says you’ll want to look at Direct Unsubsidized loans.

These loans are available to more people than the Subsidized loans and require borrowers to start making payments as soon as the loan is taken out. Unsubsidized loans also accrue interest while you are in school.

New Direct Unsubsidized loans for the 2023-2024 school year carry a fixed interest rate of 5.50% for undergraduates and 7.05% for graduate students.



As a third option, parents can help their kids by taking out PLUS loans, which are issued at a fixed rate of 8.05% for 2023-2024. A parent can borrow up to the cost of attendance — which is determined by the school — minus any financial aid the student receives. PLUS loans are also available for graduate and professional students, who are no longer considered dependents.

4. How Do You Apply for Federal Student Loans?

The very first step in applying for any federal student loans is to fill out a form called the FAFSA. FAFSA stands for 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.

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

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

Filling out and submitting the FAFSA is free — so don’t let a scammer try to tell you otherwise.

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

  • Your Social Security number or Alien Registration Number (if you are not a U.S. citizen)
  • Your parents’ Social Security number if you’re a dependent student
  • Your driver’s license if you have one
  • Your most recent federal income tax returns, W-2s, and other records of money earned
  • Bank statements and records of investments
  • Records of any untaxed income

Student loans are just one type of financial aid. After you submit your FAFSA form, your school will let you know if federal student loans are a part of your aid package.

5. How Much Money Can You Borrow?

As you can see from the chart above, the maximum amount you can borrow through federal loans per year currently ranges from $3,500 up to the total cost of attendance, minus any financial aid.

The total aggregate amount you can borrow over the course of your education currently stands at:

  • $31,000 for dependent undergraduate students whose parents are able to obtain PLUS loans (with no more than $23,000 in subsidized loans)
  • $57,000 for independent undergraduate students (with no more than $23,000 in subsidized loans)
  • $138,500 for graduate or professional students, including all federal loans for undergraduate study (with no more than $65,000 in subsidized loans)

But just because you can borrow that much money doesn’t necessarily mean you should. Here are Clark’s top four tips regarding borrowing for college:

  • Never borrow more for a four-year degree than the entry-level salary you expect to earn your first year after receiving that degree.
  • Consider doing the first two years of your studies at a community college, then transferring those credits to the school from which you want your degree.
  • If you’re a parent, never take out a loan like a Parent PLUS loan for a child if you haven’t already made sure your retirement will be fully funded.
  • Again: Never borrow any private student loan money! If a degree exceeds what you can borrow under the federal student loan program, you should either pick a cheaper school or work your way through school.

Pentis’s advice mirrors Clark’s:

“You should take out as little student loan debt as possible. You can do that by going the community college route for two years, living at home, zeroing in on cheaper four-year schools and earning an income while you’re enrolled. Applying for state grants and private scholarships are also keys to success.”

6. How Much Interest Will You Pay?

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.

Interest rates for federal student loans currently range from 5.50% for undergraduate Stafford Loans to 8.05% for PLUS loans. Keep in mind that with subsidized loans, interest does not accrue while you’re in school. With unsubsidized and PLUS loans, interest accrues from day one.

To get an idea of what a federal student loan may actually cost you, let’s look at an example.

Let’s say you follow Clark’s advice and only want to take out subsidized loans. You need $12,000 to complete school and it’s going to take you 15 years to pay back, starting six months after you graduate.

Image via SmartAsset’s Student Loan Calculator

Your payment is going to be a seemingly manageable $98 a month. But if you multiply that by the 180 months that you’ll be paying it, the total is $17,640. That means that you’ll be paying $5,640 in interest alone to pay that original $12,000 back.

Of course, if you get loans at higher interest rates — PLUS loans or private loans, for example — or take longer to pay back your loans, you’ll pay even more in interest.

None of this is to say that you shouldn’t take out federal student loans. It’s just that you need to be aware of the impact that they will have on you after you graduate.


7. How Do You Pay Student Loans Back?

On that note, let’s take a look at how that payback actually works.

First of all, if you’re still in school and have unsubsidized loans that are accruing interest, you should try to make payments each month if 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.

Once you’ve graduated, you pay back your student loans just as would any other money you’ve borrowed. However, there are some programs that can help you pay back your loans — if you only take out federal student loans.

Repayment Programs

These programs are classified as Income Driven Repayment (IDR) plans by the government. Again, these programs do not apply to private loans.

ProgramWho qualifies?What do you get?
Income-based Repayment (IBR)Federal student loan borrowers, except Parent PLUS Loans or Consolidation loans that include at least one Parent PLUS loanMonthly payments that are generally equal to 10% of your discretionary income, divided by 12, if you are a new borrower. Any loan balances are forgiven after 20 years of on-time payments
Pay As You Earn Repayment (PAYE)Federal student loan borrowers, except Parent PLUS Loans or Consolidation loans that include at least one Parent PLUS loanCaps your monthly payments on federal loans at 10% of your discretionary income, divided by 12. Any loan balances are forgiven after 20 years of on-time payments
Revised Pay As You Earn Repayment (REPAYE)Federal student loan borrowers, except PLUS Loans or Consolidation loans that include at least one Parent PLUS loanCaps your monthly payments on federal loans at 10% of your discretionary income, divided by 12. Any loan balances are forgiven after 20 years of on-time payments if you are only repaying undergraduate debt, 25 years if repaying any graduate debt

If you qualify for any of these plans, 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.

Federal Loan Consolidation

If you have multiple federal loans, you might want to consider federal loan consolidation.

A Direct Consolidation Loan allows you to combine various student loans into one loan. You would have a single monthly payment instead of multiple payments and you may be able to extend your repayment period.

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

Cons of consolidation:

  • By extending your repayment period, you will have to make more payments and pay more in interest (although you could still pay the loan off faster than the scheduled repayment term)
  • Your monthly payments may increase
  • When you consolidate, you lose any borrower benefits that were offered with your original loans
  • Once you consolidate, it cannot be undone


If you find at some point while paying back your federal student loans that interest rates on private loans have dropped to a point where they’re lower than the rates you’re paying, you might want to consider refinancing. However, there are some things to take into account.

Federal student loans come with a lot of built-in protections, including deferment and forbearance options.

Deferment allows you to delay paying your loan for a period of time without accruing additional interest.

Forbearance lets you postpone or temporarily reduce your payments if necessary when times are tough — though interest still continues to accrue while you’re in forbearance.

“It’s a rare situation where it makes sense to refinance because you lose so much, like the forbearance rights if you become unemployed,” Clark says. “With federal student loans, you’ve got to be very thoughtful and careful before agreeing to a refinance. It’s got to be worth it for you to do it.”

Clark’s rule for when it makes sense to refinance your federal student loans to private loans is that you must be able to save two full percentage points with your new interest rate (for example, going from an 8.25% interest rate to 6.25%).

“I figure the borrower protections on the federal loans are worth about two interest rate points,” he says.

If you have private student loans, refinancing might be a more attractive option.

Read more about how to refinance your student loans here.


Final Thought

Federal student loans can be a great way to make up a money shortfall if you’re going to further your education. Just remember Clark’s rules about how much you should borrow, avoid private loans if at all possible, and make sure you’ll be in a position to pay your loans back. If you play it smart, that investment in your future should be well worth it.

Have more questions about student loans? Contact Team Clark’s free Consumer Action Center.

Do you have experience with Federal and Private Student Loans? Let us know about your experience in our Community!